Liquidity Traps in a Monetary Union

The closed economy macro literature has shown that a liquidity trap can result from the
self-fulfilling expectation that future inflation and output will be low (Benhabib et al.
(2001)). This paper investigates expectations-driven liquidity traps in a two-country New
Keynesian model of a monetary union. In the model here, country-specific productivity
shocks induce synchronized responses of domestic and foreign output, while countryspecific
aggregate demand shocks trigger asymmetric domestic and foreign responses.
A rise in government purchases in an individual country lowers GDP in the rest of the
union. The result here cast doubt on the view that, in the current era of ultra-low interest
rates, a rise in fiscal spending by Euro Area (EA) core countries would significantly boost
GDP in the EA periphery (e.g. Blanchard et al. (2016)).