Step away from the zero lower bound: Small open economies in a world of secular stagnation

Abstract

We study how small open economies can engineer an escape from deflation and unemployment in a global secular stagnation. Building on the framework of Eggertsson et al. (2016), we show that the transition to full employment requires a dynamic depreciation of the exchange rate, without prejudice for domestic inflation targeting. However, if depreciation has strong income and valuation effects, the escape can be beggar thy self, raising employment but actually lowering welfare. We show that, while a relaxation in the Effective Lower Bound (ELB) can work as a means of raising employment and inflation in financially closed economies, it may have exactly the opposite effect when economies are financially open.