Long-Term Financial Contracts in an Endowment Economy of the Eggertsson-Krugman Model

Abstract

Abstract. This paper extends the endowment economy model of Eggertsson and Krugman (2012) by allowing for various durations of financial contracts. This extension might change the way that monetary policy affects the economy. Lower nominal interest rate appreciates the real value of outstanding long term debt and forces indebted consumers to cut their consumption. This contractionary effect partially offsets the standard expansionary effect of low interest rates. Longer financial contracts make this unconventional offsetting larger. The expansionary effect of commitment to future inflation, on the other hand, does not depend on the length of financial contracts.Keywords: Deleveraging, debt deflation, monetary policy. IntroductionHousehold debt plays a significant role in the studies of the current Great Recession. According to Hall (2011), tightening of household borrowing constraint forced borrowers to reduce their consumption drastically and generated a deleveraging shock that pushed the economy toward a recession. Ueda (2012) argues that a major lesson from the recent experience of the U.S. and Japan is that deleveraging can generate significant negative macroeconomic externalities. Changes in the real value of outstanding debt are crucial in understanding this channel. Falling prices increase the real burden of nominal debt, leading to a vicious circle identified by Fisher (1933) in the context of the Great Depression. The current relevance of this "Fisherian" debt deflation is emphasized by Eggertsson and Krugman (2012), denoted here as EK.The focus of this paper is on unanticipated changes in nominal interest rates as another channel that affects the real value of debt. Falling interest rates raise the value of outstanding debt and force indebted consumers to deleverage and cut their consumption. In order to study this effect we extend the endowment economy part of the EK model by introducing financial contracts of various lengths: short run contracts are one period long, two period contracts, and long contracts in the form of perpetuities.When financial contracts are short, nominal interest rate impacts the economy in a standard way. Higher nominal rate, for a given real rate, implies higher expected inflation and lower price level. This is Fisherian debt deflation that raises the real value of the outstanding debt, reduces consumption of the borrower and lowers the real interest rate to increase consumption of the lender.When contracts are long, on the other hand, there is another channel by which interest rates affect the economy. This channel works in the opposite direction than the standard one as higher nominal rate depreciates the real value of outstanding debt. This allows the borrower to consume more and consequently lowers saver's consumption and raises the real interest rate. The overall effect on the economy is therefore potentially ambiguous. We show that the standard contractionary effect of higher interest rates is still dominant, but it becomes weaker as the financial contract becomes longe...