Household debt, aggregate demand, and instability in a Stock-Flow model

This paper aims to study the effect of the increase in households’ debt on the economy. Starting from some empirical facts we develop a theoretical model that tries to replicate some of the dynamics in place in Anglo-Saxon economies before the financial crisis. In the model, we emphasize the role played by changing behavioural attitudes towards consumption and demand for loans by households that have led to an increase in financial instability in some advanced economies. The model is able to show the Janus-like faces of households’ debt: borrowing to finance consumption increases the level of aggregate demand and income, as in the standard Keynesian model and the multiplier-accelerator model by Samuelson, but at the same time fresh borrowing increases the level of the stock of debt. The stock of debt puts contractionary pressure on the aggregate demand because the repayment affects money balances and transfers resources from the high propensity to spend agents, to the low propensity to spend agents. The interaction of these phenomena creates a “predator-prey” type model in which fresh borrowing increases income, which feeds the ability to borrow more and consume; at the same time, the stock of accumulated debt “preys” on income due to the contractionary forces of the repayment mechanism.