Debt Deflation Effects of Monetary Policy

39 Pages Posted: 23 May 2014 Last revised: 18 Jun 2015

See all articles by Li Lin

Li Lin

International Monetary Fund (IMF)

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Alexandros Vardoulakis

Board of Governors of the Federal Reserve System

Date Written: May 7, 2014

Abstract

This paper assesses the role that monetary policy plays in the decision to default using a General Equilibrium model with collateralized loans, trade in fiat money and production. Long-term nominal loans are backed by collateral, the value of which depends on monetary policy. The decision to default is endogenous and depends on the relative value of the collateral to face value of the loan. Default results in foreclosure, higher borrowing costs, inefficient investment and a decrease in total output. We show that pre-crisis contractionary monetary policy interacts with Fisherian debt-deflation dynamics and can increase the probability that a crisis occurs.

Keywords: Default, collateral, debt deflation

JEL Classification: E4, E5, G0, G1, G2

Suggested Citation

Lin, Li and Tsomocos, Dimitrios P. and Vardoulakis, Alexandros, Debt Deflation Effects of Monetary Policy (May 7, 2014). FEDS Working Paper No. 2014-37, Saïd Business School WP 2014-7, Available at SSRN: https://ssrn.com/abstract=2439817 or http://dx.doi.org/10.2139/ssrn.2439817

Li Lin

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

Alexandros Vardoulakis (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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