# Debt-deflation versus the liquidity trap: the dilemma of nonconventional monetary policy

- 443 Downloads
- 1 Citations

## Abstract

This paper examines quantity-targeting monetary policy in a two-period economy with fiat money, durable goods and default. Short positions in long-term loans are backed by collateral, the value of which depends on monetary policy. The Quantity Theory of Money turns out to be compatible with long-run non-neutrality of money. Moreover, we show that, provided it does not lead to a liquidity trap, an expansionary monetary policy reduces markets’ inefficiency. Finally, we prove that, as the quantity of Bank money injected in the economy grows to infinity, only three scenarios can asymptotically emerge: (1) either the economy enters a liquidity trap in the first period, because the monetary expansion is not credible; (2) or a credible expansionary monetary policy accompanies the orderly functioning of markets at the cost of fueling inflation on the commodity market; (3) else, the money injected by the central bank increases the leverage of indebted investors, fueling a financial bubble whose bursting may lead to debt-deflation in the next period. This dilemma of monetary policy highlights the default channel affecting trades and production and provides a rigorous foundation to Fisher’s debt-deflation theory as being distinct from Keynes’ liquidity trap. It sheds some light on the pros and contrast of non-conventional monetary policies.

## Keywords

Central bank Liquidity trap Quantitative easing Collateral Default Debt-deflation## JEL Classification

D50 E40 E44 E50 E52 E58 G38 H50## Notes

### Acknowledgments

We wish to thank Christian Hellwig, Thomas Mariotti, Udara Peiris, Herakles Polemarchakis, Dimitrios Tsomocos, Alexandros Vardoulakis and Myrna Wooders for fruitful discussions, as well as participants of seminars at Paris-1 university, Paris School of Economics, Bielefeld, Naples, Vigo, Toulouse School of Economics, Exeter (EWGET12), Taipei (PET 12) and the Central Bank of Austria. The usual *caveat* applies.

## References

- Cao, D.: Collateral shortages, asset price and investment volatility with heterogeneous beliefs. Working Paper, MIT (2010)Google Scholar
- Clower, R.: A reconsideration of the micro-foundations of monetary theory. West. Econ. J.
**1**(6), 1–8 (1967)Google Scholar - Cornet, B., Gopalan, R.: Arbitrage and equilibrium with portfolio constraints. Econ. Theory
**45**(1), 227–252 (2010)CrossRefGoogle Scholar - Darrell, D., Shafer, W.: Equilibrium in incomplete markets: I: a basic model of generic existence. J. Math. Econ.
**14**(3), 285–300 (1985)CrossRefGoogle Scholar - Dubey, P., Geankoplos, J.: Competitive pooling: Rothschild–Stiglitz reconsidered. Q. J. Econ.
**117**(4), 1529–1570 (2002)CrossRefGoogle Scholar - Dubey, P., Geanakoplos, J.: Inside and outside money, gains to trade, and IS-LM. Econ. Theory
**21**(2), 347–397 (2003a)CrossRefGoogle Scholar - Dubey, P., Geanakoplos, J.: Monetary equilibrium with missing markets. J. Math. Econ.
**39**(5–6), 585–618 (2003b)CrossRefGoogle Scholar - Dubey, P., Geanakoplos, J.: Determinacy with nominal assets and outside money. Econ. Theory
**27**(1), 79–106 (2006a)CrossRefGoogle Scholar - Dubey, P., Geanakoplos, J.: Money and production, and liquidity trap. Int. J. Econ. Theory
**2**(3–4), 295–317 (2006b)CrossRefGoogle Scholar - Eggertson, G.B., Woodford, M.: The zero bound on interest rates and optimal monetary policy. Brook. Pap. Econ. Act.
**34**(1), 139–235 (2003)CrossRefGoogle Scholar - Geanakoplos, J.: An introduction to general equilibrium with incomplete markets. J. Math. Econ.
**19**(1–2), 1–38 (1990)CrossRefGoogle Scholar - Geanakoplos, J., Polemarchakis, H.: Walrasian indeterminacy and keynesian macroeconomics. Rev. Econ. Stud.
**53**(5), 755–779 (1986)CrossRefGoogle Scholar - Geanakoplos, J., Zame, W.R.: Collateral equilibrium, I: a basic framework. Econ. Theory
**56**(3), 443–492 (2014)CrossRefGoogle Scholar - Giraud, G.: Strategic market game: an introduction. J. Math. Econ.
**39**(5–6), 355–375 (2003)CrossRefGoogle Scholar - Giraud, G., Pottier, A.: Debt deflation versus liquidity trap: the dilemma of nonconventional monetary policy. CES Working Paper, 2012.64, University Paris 1 (2012)Google Scholar
- Giraud, G., Stahn, H.: Efficiency and imperfect competition in economies with incomplete markets. J. Math. Econ.
**39**(5–6), 559–583 (2003)CrossRefGoogle Scholar - Hart, O.: On the optimality of equilibrium when the asset structure is incomplete. J. Econ. Theory
**11**(3), 418–443 (1975)CrossRefGoogle Scholar - Hellwig, M.F.: Bankruptcy, limited liability, and the Modigliani–Miller theorem. Am. Econ. Rev.
**71**(1), 155–170 (1982)Google Scholar - Kehoe, T.J., Levine, D.K.: Debt-constrained asset markets. Rev. Econ. Stud.
**60**(4), 865–888 (1993)CrossRefGoogle Scholar - Krugman, P.: Thinking about the liquidity trap. J. Jpn. Int. Econ.
**14**, 221–237 (2000)CrossRefGoogle Scholar - Lin, L., Tsomocos, D., Vardoulakis, A.: Debt deflation effects of monetary policy. Oxford Working Paper (2010a)Google Scholar
- Lin, L., Tsomocos, D., Vardoulakis, A.: On default and uniqueness of monetary equilibria. Oxford Working Paper (2010b)Google Scholar
- Meier, A.: Panacea, curse or nonevent? Unconventional monetary policy in the United Kingdom. iMF Working Paper No. 09/163 (2009)Google Scholar
- Mendoza, E.G.: Sudden stops, financial crises, and leverage. Am. Econ. Rev.
**5**(100), 1941–1965 (2010)Google Scholar - Orphanides, A.: Monetary policy in deflation: the liquidity trap in history and practice. N. Am. J. Econ. Finance
**15**(1), 101–124 (2004)CrossRefGoogle Scholar - Orrillo, J.: Existence of a collateral equilibrium without survival assumption. Est. Econ.
**41**(1), 7–24 (2011)CrossRefGoogle Scholar - Reinhart, C., Rogoff, K.: This Time is Different: Eight Centuries of Financial Folly. Princeton University Press, Princeton and Oxford (2009)Google Scholar
- Schularick, M., Taylor, A.: Credit booms gone bust: monetary policy, leverage cycles, and financial crises—1870–2008. Am. Econ. Rev.
**102**(2), 1029–1061 (2012)CrossRefGoogle Scholar - Stiglitz, J.E.: The inefficiency of the stock market equilibrium. Rev. Econ. Stud.
**49**(2), 241–261 (1982)CrossRefGoogle Scholar - Taylor, J.B.: Getting Off Track—How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis. Hoover Institution, Stanford University, Stanford (2009)Google Scholar
- Woodford, M.: Monetary policy and price level determinacy in a cash-in-advance economy. Econ. Theory
**4**(3), 345–380 (1994)CrossRefGoogle Scholar - Woodford, M.: Interest and Prices: Foundations of a Theory of Monetary. Princeton University Press, Princeton (2003)Google Scholar