Working Paper: CEPR ID: DP10469
Authors: Luca Fornaro
Abstract: This paper provides a framework to understand debt deleveraging in a group of financially integrated countries. During an episode of international deleveraging, world consumption demand is depressed and the world interest rate is low, reflecting a high propensity to save. If exchange rates are allowed to float, deleveraging countries can rely on depreciations to increase production and mitigate the fall in consumption associated with debt reduction. The key insight of the paper is that in a monetary union this channel of adjustment is shut off, because deleveraging countries cannot depreciate against the other countries in the monetary union, and therefore the fall in the demand for consumption and the downward pressure on the interest rate are amplified. Hence, deleveraging can easily push a monetary union against the zero lower bound and into a recession.
Keywords: Debt; Deflation; Global Debt Deleveraging; Liquidity Trap; Monetary Union; Precautionary Savings; Sudden Stops
JEL Codes: E31; E44; E52; F32; F34; F41; G01; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| tightening of borrowing limits (F65) | increased savings (D14) |
| increased savings (D14) | depressed consumption (E21) |
| depressed consumption (E21) | drop in world interest rate (E43) |
| tightening of borrowing limits (F65) | depressed consumption (E21) |
| depressed consumption (E21) | economic contraction (F44) |
| tightening of borrowing limits (F65) | drop in world interest rate (E43) |
| tightening of borrowing limits (F65) | liquidity trap (E41) |
| tightening of borrowing limits (F65) | exacerbation of recession in high-debt countries (F65) |