Debt-Deflation: Concepts and a Stylised Model

57 Pages Posted: 20 Sep 2007  

Goetz von Peter

Bank for International Settlements - Research and Policy Analysis

Date Written: April 2005

Abstract

This paper proposes a model of how agents adjust their asset holdings in response to losses in general equilibrium. By emphasising the relation between deflation and financial distress, we capture some original features of the early debt-deflation literature, such as distress selling, instability, and endogenous monetary contraction.

The agents affected by a shock sell off assets to prevent their debt from crowding out consumption. But their distress-selling causes a decline in equilibrium prices, and the resulting losses elicit reactions by all agents. This activates several channels of debt-deflation. Yet we show that this process remains stable, even in the presence of large shocks, high indebtedness, and wide-spread default. What keeps the asset market stable is the presence of agents without prior debt or losses, who borrow to exploit the expected asset price recovery. By contrast, debt-deflation becomes unstable when agents try to contain their indebtedness, or when a credit crunch interferes with the accommodation necessary for stability.

Keywords: Debt-Deflation, Leverage, Refinancing, Losses, Financial Distress, Distress Selling, Asset Prices, Credit, Inside Money

JEL Classification: E31, E51, G33, G21, G18

Suggested Citation

von Peter, Goetz, Debt-Deflation: Concepts and a Stylised Model (April 2005). BIS Working Paper No. 176. Available at SSRN: https://ssrn.com/abstract=721541 or http://dx.doi.org/10.2139/ssrn.721541

Goetz Von Peter (Contact Author)

Bank for International Settlements - Research and Policy Analysis ( email )

CH-4002 Basel, Basel-Stadt
Switzerland
+ 41 61 280 8840 (Phone)

HOME PAGE: http://www.bis.org/author/goetz_von_peter.htm

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