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

Abstract

This paper examines quantity-targeting monetary policy in a two-period economy with fiat money, endogenously incomplete markets of financial securities, durable goods and production. Short positions in financial assets and long-term loans are backed by collateral, the value of which depends on monetary policy. The decision to default is endogenous and depends on the relative value of the collateral to the loan. We show that Collateral Monetary Equilibria exist and prove a refinement of the Quantity Theory of Money that turns out to be compatible with the long-run non-neutrality of money. Moreover, only three scenarios are compatible with the equilibrium condition: 1) either the economy enters a liquidity trap in the first period; 2) or a credible expansionary monetary policy accompanies the orderly functioning of markets at the cost of running an inflationary risk; 3) else the money injected by the Central Bank increases the leverage of indebted investors, fueling a financial bubble whose bursting leads to debt-deflation in the next period with a non-zero probability. 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.

Money and inflation in inflation-targeting regimes – new evidence from time–frequency analysis

“…The financial system, filled with abundant liquidity and characterized by fundamental changes of money and credit (Ryczkowski, 2020;Schularick & Taylor, 2012), caused others to deliberate on the possible unintended medium-and longer-run consequences of such an "ultra-easy" monetary policy (Ciżkowicz & Rzońca, 2017). In particular, the accommodative monetary policy created concerns about its inflationary risks (Giraud & Pottier, 2016;van den End, 2016). Notably, Taylor (2019), and Belongia and Ireland (2018) argue for targeting the growth rate of monetary aggregates in the post-crisis environment.…”