Debt-Deflation versus the Liquidity Trap: The Dilemma of Nonconventional Monetary Policy
This paper examines quantity-targeting monetary policy in a two-period economy with fiat money, endogenously incomplete markets of financial securities, durable goods and production. Short positions in financial assets and long-term 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 the loan. We show that Collateral Monetary Equilibria exist and prove there is also a refinement of the Quantity Theory of Money that turns out to be compatible with the long-run non-neutrality of money. Moreover, only three scenarios are compatible with the equilibrium condition : 1) either the economy enters a liquidity trap in the first period ; 2) or a credible ex-pansionary monetary policy accompanies the orderly functioning of markets at the cost of running an inflationary risk ; 3) else the money injected by the Central Bank increases the leverage of indebted investors, fueling a financial bubble whose bursting leads to debt-deflation in the next period with a non-zero probability. This dilemma of monetary policy highlights the default channel affecting trades and production, and provides a rigorous foundation to Fisher’s debt deflation theory as being distinct from Keynes’ liquidity trap.
|Date of creation:||Oct 2012|
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- Tobias Adrian & Hyun Song Shin, 2008.
"Liquidity and leverage,"
328, Federal Reserve Bank of New York.
- Enrique G. Mendoza & Katherine A. Smith, 2004.
"Quantitative Implication of A Debt-Deflation Theory of Sudden Stops and Asset Prices,"
NBER Working Papers
10940, National Bureau of Economic Research, Inc.
- Mendoza, Enrique G. & Smith, Katherine A., 2006. "Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices," Journal of International Economics, Elsevier, vol. 70(1), pages 82-114, September.
- Fabio Panetta & Paolo Angelini & Ugo Albertazzi & Francesco Columba & Wanda Cornacchia & Antonio Di Cesare & Andrea Pilati & Carmelo Salleo & Giovanni Santini, 2009. "Financial sector pro-cyclicality: lessons from the crisis," Questioni di Economia e Finanza (Occasional Papers) 44, Bank of Italy, Economic Research and International Relations Area.
- John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
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