Debt-deflation versus the liquidity trap: the dilemma of nonconventional monetary policy

Gaël Giraud and Antonin Pottier

Economic Theory, 2016, vol. 62, issue 1, No 17, 383-408

Abstract: Abstract This paper examines quantity-targeting monetary policy in a two-period economy with fiat money, durable goods and default. Short positions in long-term loans are backed by collateral, the value of which depends on monetary policy. The Quantity Theory of Money turns out to be compatible with long-run non-neutrality of money. Moreover, we show that, provided it does not lead to a liquidity trap, an expansionary monetary policy reduces markets’ inefficiency. Finally, we prove that, as the quantity of Bank money injected in the economy grows to infinity, only three scenarios can asymptotically emerge: (1) either the economy enters a liquidity trap in the first period, because the monetary expansion is not credible; (2) or a credible expansionary monetary policy accompanies the orderly functioning of markets at the cost of fueling inflation on the commodity market; (3) else, the money injected by the central bank increases the leverage of indebted investors, fueling a financial bubble whose bursting may lead to debt-deflation in the next period. This dilemma of monetary policy highlights the default channel affecting trades and production and provides a rigorous foundation to Fisher’s debt-deflation theory as being distinct from Keynes’ liquidity trap. It sheds some light on the pros and contrast of non-conventional monetary policies.

Keywords: Central bank; Liquidity trap; Quantitative easing; Collateral; Default; Debt-deflation (search for similar items in EconPapers)
JEL-codes: D50 E40 E44 E50 E52 E58 G38 H50 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (6)

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Related works:
Working Paper: Debt-deflation versus liquidity trap: the dilemma of nonconventional monetary policy (2016)
Working Paper: Debt-Deflation versus the Liquidity Trap: the Dilemma of Nonconventional Monetary Policy (2012)
Working Paper: Debt-Deflation versus the Liquidity Trap: the Dilemma of Nonconventional Monetary Policy (2012)
Working Paper: Debt-Deflation versus the Liquidity Trap: The Dilemma of Nonconventional Monetary Policy (2012)
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DOI: 10.1007/s00199-015-0914-7

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