Analyzing the Amplification Mechanisms of Debt Deleveraging

14/09/2022 |  Cohen Nimrod
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The Financial Markets and Financial Stability


This study examines a model of an economic-financial crisis caused by sudden debt deleveraging in the economy. In this type of crisis, there is a negative impact to demand and the monetary interest rate may be reduced to its lower bound—a phenomenon referred to as a “liquidity trap”—such that monetary policy is limited in its response (Eggertsson and Woodford, 2003). In parallel, there are other mechanisms that may increase the intensity of the crisis, such as a financial accelerator mechanism (Bernanke et al., 1999) or a debt deflation mechanism (Eggertson and Krugman, 2012). The question then is, what is the contribution of the various mechanisms to the crisis—and particularly, what is the interaction between them.

For this purpose, we build a model of general equilibrium in a New Keynesian framework with two types of representative agents—a borrower and a saver—where the borrower’s financial spread depends on his level of leverage (ratio of debt to financial assets). The model is solved without linearization, with an emphasis on the monetary policy rule that includes a lower bound for the interest rate, in order to enable an analysis of the interactions between the various mechanisms.

An analysis of the economy’s response to the reduced leverage in various cases shows that the interaction of the various mechanisms is very significant. For instance, when the economy enters a liquidity trap the effect of the financial accelerator greatly intensifies the crisis, far beyond a case where the interest rate is not limited. Essentially, the analysis illustrates the importance of effective monetary policy during a financial crisis, since monetary accommodation in such a situation is critical in preventing a much worse crisis.

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