Safe Asset Scarcity and Aggregate Demand

Author:

Caballero Ricardo J.1,Farhi Emmanuel2,Gourinchas Pierre-Olivier3

Affiliation:

1. Department of Economics, Massachusetts Institute of Technology, 77 Massachusetts Avenue, Building E52-528, Cambridge, MA 02139 (e-mail: )

2. Department of Economics, Harvard University, Littauer 318, 1805 Cambridge Street, Cambridge, MA 02138 (e-mail: )

3. Department of Economics, University of California-Berkeley, 697D Evans Hall, #3880, Berkeley, CA 94720 (e-mail: )

Abstract

We explore the consequences of safe asset scarcity on aggregate demand in a stylized IS-LM/Mundell Fleming style environment. Acute safe asset scarcity forces the economy into a “safety trap” recession. In the open economy, safe asset scarcity spreads from one country to the other via capital flows, equalizing interest rates. Acute global safe asset scarcity forces the economy into a global safety trap. The exchange rate becomes indeterminate but plays a crucial role in both the distribution and the magnitude of output adjustment across countries. Policies that increase the net supply of safe assets somewhere are output enhancing everywhere.

Publisher

American Economic Association

Subject

Economics and Econometrics

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