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Debt-Ridden Equilibria - A Simple Theory of Great Depressions -

  • KOBAYASHI Keiichiro
  • INABA Masaru (RIETI)

The US Great Depression and Japan's lost decade in the 1990s are both characterized as persistent stagnations of economies with debt-ridden corporate sectors subsequent to asset-price collapses. We propose a simple model, in which increases in corporate debt (and/or fluctuations in expectations about the future state of the economy) can account for these episodes. Key ingredients are the assumptions that firms are subject to collateral constraint on liquidity for financing the inputs, and that the firms can hold other firms' stocks as their assets and use them as the collateral. Collateral constraint on inputs interlinks the financial market inefficiency with the factor market inefficiencies; and that the corporate stocks are used as collateral generates an externality of self-reference in stock prices and production, that is, higher stock prices loosen the collateral constraint and lead to higher efficiencies in production, which in turn justify the higher stock prices. It is shown that there exists a continuum of steady-state equilibria indexed by the amount of debt that the firms owe to the consumers: A steady state with a larger debt can be called a debt-ridden equilibrium, since it has more inefficient factor markets, produces less output, and is characterized by lower stock prices. The model provides the policy implication that debt reduction in the corporate sector at the expense of consumers (or taxpayers) may be welfare-improving when the firms are debt-ridden.

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Paper provided by Research Institute of Economy, Trade and Industry (RIETI) in its series Discussion papers with number 07035.

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Length: 23 pages
Date of creation: Jun 2007
Date of revision:
Handle: RePEc:eti:dpaper:07035
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  1. V. V. Chari & Patrick Kehoe & Ellen McGrattan, 2004. "Business Cycle Accounting," Levine's Bibliography 122247000000000560, UCLA Department of Economics.
  2. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Avoiding Liquidity Traps," CEPR Discussion Papers 2948, C.E.P.R. Discussion Papers.
  3. Keiichiro Kobayashi & Masaru Inaba, 2006. "Business cycle accounting for the Japanese economy," 2006 Meeting Papers 313, Society for Economic Dynamics.
  4. Kobayashi, Keiichiro & Nakajima, Tomoyuki & Inaba, Masaru, 2012. "Collateral Constraint And News-Driven Cycles," Macroeconomic Dynamics, Cambridge University Press, vol. 16(05), pages 752-776, November.
  5. Timothy J. Kehoe & Edward C. Prescott, 2002. "Great Depressions of the Twentieth Century," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(1), pages 1-18, January.
  6. Keiichiro Kobayashi, 2004. "Transaction services and asset-price bubbles," Discussion papers 04026, Research Institute of Economy, Trade and Industry (RIETI).
  7. Casey B. Mulligan, 2002. "A Dual Method of Empirically Evaluating Dynamic Competitive Equilibrium Models with Market Distortions, Applied to the Great Depression & World War II," NBER Working Papers 8775, National Bureau of Economic Research, Inc.
  8. Harold L. Cole & Lee E. Ohanian, 1999. "The Great Depression in the United States from a neoclassical perspective," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-24.
  9. Keiichiro Kobayashi & Masaru Inaba, 2006. "Borrowing constraints and protracted recessions," Discussion papers 06011, Research Institute of Economy, Trade and Industry (RIETI).
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