Economic Theory

, Volume 62, Issue 1–2, pp 383–408 | Cite as

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

  • Gaël Giraud
  • Antonin Pottier
Research Article


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.


Central bank Liquidity trap Quantitative easing  Collateral Default Debt-deflation 

JEL Classification

D50 E40 E44 E50 E52 E58 G38 H50 



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.


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Copyright information

© Springer-Verlag Berlin Heidelberg 2015

Authors and Affiliations

  1. 1.Centre d’Economie de la Sorbonne, CNRSAgence Française de DéveloppementParisFrance
  2. 2.CERNA - Centre for Industrial Economics, MINES ParisTechPSL Research UniversityParisFrance

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