Analysis of the Amplification Mechanisms in the Process of Debt Deleveraging

Nimrod Cohen ()
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Nimrod Cohen: Bank of Israel

No 2022.16, Bank of Israel Working Papers from Bank of Israel

Abstract: This research examines a model of an economic-financial crisis caused by a sudden debt deleveraging in the economy. In this type of a crisis, demand is contracted, and the monetary interest rate may drop to its effective lower bound – a phenomenon called the "liquidity trap" – in such a way, that the monetary policy is restricted in its response (Eggertsson and Woodford, 2003). At the same time, there are other mechanisms that may intensify the crisis, such as the mechanism of the "financial accelerator" (Bernanke et al., 1999), and the mechanism of the "debt deflation" (Eggertsson and Krugman, 2012). Therefore, we are induced to question, what is the "contribution" of those various mechanisms to this crisis, and in particular - what is the interaction between those mechanisms. For this purpose, a general equilibrium model has been built in a Neo- Keynesian framework with two types of representative agents – a borrower and a saver – where the financial spread of the borrower depends on his or her level of leverage (the ratio of debt to the value of assets). The model is solved without linearization, emphasizing the monetary policy rule, which includes an effective lower bound on the interest rate. This is to enable an analysis of the interactions between the various mechanisms. From the analysis of the reaction of the economy to the debt deleveraging in the various situations, it was found that the interaction of the various mechanisms is extremely significant. For example, when the economy enters the "liquidity trap", the effect of the "financial accelerator" is intensifying the crisis to a great extent, much more than it occurs in a situation where the interest rate is not subject to the effective lower bound. In fact, the analysis illustrates the importance of an effective monetary policy in the course of a financial crisis, because monetary expansion is critical in this situation and prevents a crisis which is much more acute.

Keywords: liquidity trap; the effective lower bound (ELB); financial friction; monetary policy; financial crisis; financial crisis; debt deleveraging; credit market; financial accelerator, debt deflation (search for similar items in EconPapers)
Pages: 55 pages
Date: 2022-09
New Economics Papers: this item is included in nep-cba, nep-dge and nep-fdg
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