Debt Overhang and Monetary Policy

We study a theory in which households borrow during the first half of a 241-period life cycle as part of a DSGE. Households confront a persistent regime-switching process on aggregate labor productivity growth. When the economy switches to the high growth regime, there is more borrowing based on expectations of higher future income. When the economy switches back to the low growth regime, some households will have borrowed "too much" given contemporaneous income levels–the hallmark of debt overhang. A powerful central bank can intervene in private credit markets to influence real yields. If the central bank does intervene to keep real rates lower, consumption will be reallocated relative to a laissez faire case. The reallocation will generally be away from those households saving for retirement and possibly away from those households that are heavy users of money to smooth income fluctuations.