Amplification of shocks at the zero lower bound in a small open and large closed economy

ABSTRACT

This letter compares the consequences of hitting the zero lower bound in small open and large closed economies. I show that in a large economy shocks are modified by the zero lower bound on interest rate much more than in a small one – as a result, the large economy may suffer more.

KEYWORDS:

• Zero lower bound
• small open economy
• amplification of shocks

JEL CLASSIFICATION:

• E52
• E43

Acknowledgement

I would like to thank Marcin Kolasa and Krzysztof Makarski for helpful comments.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ A detailed description of the model can be found in the working paper version of this letter (National Bank of Poland Working Paper No. 230).

² This means that shocks that can occur only in one of the economies (e.g. international risk premium shocks) are beyond the scope of this study.

³ To be precise, I first calculate the shocks to LCE such that the economy is trapped at the ZLB for 8 quarters. Then I turn these shocks off and calculate the series of preference shocks in the SOE such that the interest rate in the unconstrained (i.e. without the ZLB) model equals exactly the interest rate path in the unconstrained LCE for 20 quarters. The resulting interest rate paths in the constrained models are the same for 14 quarters (i.e. until the ZLB stops binding) and differ only marginally thereafter.