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Debt-Deflation versus the Liquidity Trap: The Dilemma of Nonconventional Monetary Policy

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    Abstract

    This paper examines quantity-targeting monetary policy in a two-period economy with fiat money, endogenously incomplete markets of financial securities, durable goods and production. Short positions in financial assets and long-term loans are backed by collateral, the value of which depends on monetary policy. The decision to default is endogenous and depends on the relative value of the collateral to the loan. We show that Collateral Monetary Equilibria exist and prove there is also a refinement of the Quantity Theory of Money that turns out to be compatible with the long-run non-neutrality of money. Moreover, only three scenarios are compatible with the equilibrium condition : 1) either the economy enters a liquidity trap in the first period ; 2) or a credible ex-pansionary monetary policy accompanies the orderly functioning of markets at the cost of running an inflationary risk ; 3) else the money injected by the Central Bank increases the leverage of indebted investors, fueling a financial bubble whose bursting leads to debt-deflation in the next period with a non-zero probability. This dilemma of monetary policy highlights the default channel affecting trades and production, and provides a rigorous foundation to Fisher’s debt deflation theory as being distinct from Keynes’ liquidity trap.

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    File URL: ftp://mse.univ-paris1.fr/pub/mse/CES2012/12064.pdf
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    Bibliographic Info

    Paper provided by Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne in its series Documents de travail du Centre d'Economie de la Sorbonne with number 12064.

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    Length: 56 pages
    Date of creation: Oct 2012
    Date of revision:
    Handle: RePEc:mse:cesdoc:12064

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    Keywords: Central Bank; liquidity trap; collateral; default; deflation; quantitative easing; debt-deflation.;

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    1. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
    2. Enrique G. Mendoza & Katherine A. Smith, 2004. "Quantitative Implication of A Debt-Deflation Theory of Sudden Stops and Asset Prices," NBER Working Papers 10940, National Bureau of Economic Research, Inc.
    3. Fabio Panetta & Paolo Angelini & Ugo Albertazzi & Francesco Columba & Wanda Cornacchia & Antonio Di Cesare & Andrea Pilati & Carmelo Salleo & Giovanni Santini, 2009. "Financial sector pro-cyclicality: lessons from the crisis," Questioni di Economia e Finanza (Occasional Papers) 44, Bank of Italy, Economic Research and International Relations Area.
    4. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
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