A Model of Debt Deflation and Disproportionate Reflation
This paper analyzes processes of deflation and reflation in a debt-constrained economy. Nominally rigid debt obligations could limit firms' ability to reduce the output prices in response to a negative aggregate demand shock, giving ride to an under-employment equilibrium. The standard policy prescription to such a situation is to inflate away the real debt burdens. Such a reflationary poliy may not work, however, if the higher money supply only increases the prices of goods supplied by debt-free agents, without changing the prices of the goods of supplied indebted firms. The resulting change in the relative prices may have contractionary effect on aggregate demand, which offsets the desired effects of the monetary transition.
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