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International debt deleveraging

I provide a framework for understanding debt deleveraging in a group of financially integrated countries. During an episode of international deleveraging world consumption demand is depressed and the world interest rate is low, reflecting a high propensity to save. If exchange rates are allowed to float, deleveraging countries can depreciate their nominal exchange rate to increase production and mitigate the fall in consumption associated with debt reduction. The key insight of the paper is that in a monetary union this channel of adjustment is shut off, and therefore the falls in consumption demand and in the world interest rate are amplified. Hence, monetary unions are especially prone to hit the zero lower bound on the nominal interest rate and enter a liquidity trap during deleveraging. In a liquidity trap deleveraging gives rise to a union-wide recession, which is particularly severe in high-debt countries. The model suggests several policy interventions that mitigate the negative impact of deleveraging on output in monetary unions.

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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1401.

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Date of creation: Nov 2012
Date of revision: Nov 2013
Handle: RePEc:upf:upfgen:1401
Contact details of provider: Web page: http://www.econ.upf.edu/

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