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Debt Deleveraging and the Zero Bound: Potentially Perverse Effects of Real Exchange Rate Movements

Author

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  • Paul Luk

    (Oxford University and Hong Kong Institute for Monetary Research)

  • David Vines

    (Oxford University and Centre for Applied Macroeconomic Analysis and Australian National University and Centre for Economic Policy Research)

Abstract

We present a microfounded two-country model of global imbalances and debt deleveraging. A sustained rise in saving in one country can lead to a worldwide fall in interest rates and an accumulation of debt in the other country. When a subsequent deleveraging shock occurs, interest rates are forced down further. In the presence of a zero bound to interest rates, the deleveraging country may face a combination of a large fall in output, deflation, a rise in real interest rates and real exchange rate appreciation. Such exchange rate appreciation will intensify the loss in output, magnify the deflation and further tighten the deleveraging constraint.

Suggested Citation

  • Paul Luk & David Vines, 2014. "Debt Deleveraging and the Zero Bound: Potentially Perverse Effects of Real Exchange Rate Movements," Working Papers 202014, Hong Kong Institute for Monetary Research.
    • Handle: RePEc:hkm:wpaper:202014
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    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance

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