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Debt deflation effects of monetary policy

Author

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  • Lin, Li
  • Tsomocos, Dimitrios P.
  • Vardoulakis, Alexandros P.

Abstract

We assess the role that monetary policy plays in the decision to default using a General Equilibrium model with collateralized loans, trade in fiat money and production. The monetary authority extends long-term credit against risky collateral along with its traditional monetary operations. The value of collateral depends on traditional monetary policy and agents can optimally choose to default depending on the relative value of the collateral to the face value of the loan. Default results in foreclosure, higher borrowing costs, inefficient investment and a decrease in total output. We show that pre-crisis contractionary monetary policy interacts with Fisherian debt-deflation dynamics and can increase the probability that a crisis occurs.

Suggested Citation

  • Lin, Li & Tsomocos, Dimitrios P. & Vardoulakis, Alexandros P., 2015. "Debt deflation effects of monetary policy," Journal of Financial Stability, Elsevier, vol. 21(C), pages 81-94.
  • Handle: RePEc:eee:finsta:v:21:y:2015:i:c:p:81-94
    DOI: 10.1016/j.jfs.2015.10.005
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    References listed on IDEAS

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    Cited by:

    1. repec:eee:finsta:v:35:y:2018:i:c:p:192-214 is not listed on IDEAS
    2. Peiris, M. Udara & Tsomocos, Dimitrios P., 2015. "International monetary equilibrium with default," Journal of Mathematical Economics, Elsevier, vol. 56(C), pages 47-57.
    3. Francis, Bill B. & Hasan, Iftekhar & Kostova, Gergana L., 2016. "When do peers matter?: A cross-country perspective," Journal of International Money and Finance, Elsevier, vol. 69(C), pages 364-389.

    More about this item

    Keywords

    Default; Collateral; Debt-deflation; Money;

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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