The Expansionary Lower Bound: Contractionary Monetary Easing and the Trilemma
IMF Working Papers, November 2, 2018
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- The Expansionary Lower Bound: Contractionary Monetary Easing and the Trilemma
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Bibliographic details
- Authors: Paolo Cavallino, Damiano Sandri
- Published: November 2, 2018
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781484381618.001
Summary of core argument
- The paper provides a theory of the limits to monetary policy independence in open economies arising from the interaction between capital flows and domestic collateral constraints.
- Introduces the concept of an “Expansionary Lower Bound” (ELB), defined as an interest rate threshold below which monetary easing becomes contractionary.
- The ELB can be positive, thus acting as a more stringent constraint than the Zero Lower Bound.
- The ELB is affected by global monetary and financial conditions, generating international spillovers and departures from Mundell’s trilemma.
- Two model frameworks are presented where the ELB may arise:
- Model 1: Carry-trade capital flows.
- Model 2: Role of currency mismatches.
Key findings and mechanisms
- Existence of ELB:
- Monetary easing can become contractionary if interest rates fall below the ELB.
- The ELB can be above zero (positive), implying a more binding constraint than the Zero Lower Bound.
- International spillovers:
- Global monetary and financial conditions influence the ELB, creating cross-border transmission of constraints and policy limits.
- Channels analyzed:
- Carry-trade capital flows can interact with domestic collateral constraints to produce an ELB.
- Currency mismatches amplify vulnerabilities and can generate ELB dynamics through balance-sheet and collateral effects.
Policy implications and relevance
- Monetary policy independence is limited by interactions between capital flows and domestic financial frictions.
- Standard policy prescriptions based on Mundell’s trilemma require revision when ELB effects are present, because policy space can be more constrained than implied by nominal interest rate bounds alone.
- Policymakers should account for global financial conditions and balance-sheet vulnerabilities (including currency mismatches) when setting policy rates to avoid contractionary outcomes from monetary easing.