A Model of Debt Deflation and the Phillips Curve: Implications for Business Cycles and the Balance Sheet Channel of Monetary Policy

Lutz Georg Arnold ()

Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), 2000, vol. 220, issue 4, pages 385-399

Abstract: New Keynesian economics stresses the positive link between firms' net worth, on the one hand, and the equilibrium level of credit granted and aggregate employment, on the other hand. The present paper argues that once money is introduced and adaptive inflation expectations are assumed, an accelerationist Phillips curve emerges: because of debt deflation, an increase in the rate of inflation reduces firms' real debt burden; because of the negative link between real debt and employment, unemployment falls. The natural rate of unemployment is the rate that occurs when inflation is constant. Frisch has proposed modeling business cycles by means of stochastic linear second-order difference equations which display damped oscillations in the absence of stochastic impulses. The New Keynesian model with adaptive expectations expounded here gives rise to business cycles in Frisch's sense. This can be shown by applying Laidler's result, derived in a different set-up, that the interaction between an accelerationist Phillips curve and the quantity theory of money yields Frisch-type cycles. Moreover, the model presented sheds some light on the working of the balance sheet channel of monetary policy.

Keywords: Business cycles; Phillips curve; debt deflation; balance sheet channel of monetary policy (search for similar items in EconPapers)
JEL-codes: E32 (search for similar items in EconPapers)
Date: 2000

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