DP10469 International Debt Deleveraging

Author(s): Luca Fornaro
Publication Date: March 2015
Keyword(s): Debt Deflation, Global Debt Deleveraging, Liquidity Trap, Monetary Union, Precautionary Savings, Sudden Stops
JEL(s): E31, E44, E52, F32, F34, F41, G01, G15
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10469

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.