Aggregate Demand Externalities in a Global Liquidity Trap

A recent literature has suggested that macroprudential policies can act as second-best stabilization tools when monetary policy is constrained by the zero lower bound. In this paper we show that, once their international dimension is taken into account, macroprudential policies can backfire. We provide a tractable multi-country framework of an imperfectly financially integrated world, in which equilibrium interest rates are low and monetary policy is occasionally constrained by the zero lower bound. Idiosyncratic shocks generate capital flows and asymmetric liquidity traps across countries. Due to a domestic aggregate demand externality, it is optimal for governments to implement countercyclical macroprudential policies, taxing borrowing in good times, as a precaution against the risk of a future liquidity trap triggered by a negative shock. The key insight of the paper is that this policy is inefficient from a global perspective, because it depresses global rates and deepens the recession in the countries currently stuck in a liquidity trap. This international aggregate demand externality points toward the need for international cooperation in the design of financial market interventions. Indeed, under the cooperative optimal financial policy countries internalize the fact that a stronger demand for borrowing and consumption from countries at full employment sustains global rates, reducing the recession in liquidity trap economies.