Staff Reports
Liquidity Traps, Capital Flows
January 2016 Number 765
Revised: August 2018
JEL classification: E52, F32, F38, F42, F44

Authors: Sushant Acharya and Julien Bengui

Motivated by debates surrounding international capital flows during the Great Recession, we conduct a positive and normative analysis of capital flows when a region of the global economy experiences a liquidity trap. Capital flows reduce inefficient output fluctuations in this region by inducing exchange rate movements that reallocate expenditure toward the goods it produces. Restricting capital mobility hampers such an adjustment. From a global perspective, constrained efficiency entails subsidizing capital flows to address an aggregate demand externality associated with exchange rate movements. Absent cooperation, however, dynamic terms-of-trade manipulation motives drive countries to inefficiently restrict capital flows, impeding aggregate demand stabilization.

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