Debt-Deflation: Concepts, and a Stylised Model

Abstract: This paper proposes a model of how agents adjust their asset holdings in response to losses in general equilibrium. By emphasising the relation between deflation and financial distress, we capture some original features of the early debt-deflation literature, such as distress selling, instability, and endogenous monetary contraction. The agents affected by a shock sell off assets to prevent their debt from crowding out consumption. But their distress-selling causes a decline in equilibrium prices, and the resulting losses elicit reactions by all agents. This activates several channels of debt-deflation. Yet we show that this process remains stable, even in the presence of large shocks, high indebtedness, and wide-spread default. What keeps the asset market stable is the presence of agents without prior debt or losses, who borrow to exploit the expected asset price recovery. By contrast, debt-deflation becomes unstable when agents try to contain their indebtedness, or when a credit crunch interferes with the accommodation necessary for stability.

Keywords: Debt-Deflation; Leverage; Refinancing; Losses; Financial Distress; Distress Selling; Asset Prices; Credit; Inside Money. (search for similar items in EconPapers)
JEL-codes: E31 E51 G33 G21 G18 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fin and nep-mac
Date: Written 2005-05-02
Note: Type of Document - pdf; pages: 54
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http://129.3.20.41/eps/mac/papers/0505/0505001.pdf (application/pdf)

Related works:
Working Paper: Debt-deflation: concepts and a stylised model (2005)
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