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Debt Deflation Effects of Monetary Policy

Author

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  • Lin, Li

    () (International Monetary Fund)

  • Tsomocos, Dimitrios P.

    () (University of Oxford)

  • Vardoulakis, Alexandros

    () (Board of Governors of the Federal Reserve System (U.S.))

Abstract

This paper assesses 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. Long-term nominal 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 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, 2014. "Debt Deflation Effects of Monetary Policy," Finance and Economics Discussion Series 2014-37, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2014-37
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    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;

    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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