Debt, Deleveraging, and the Liquidity
Trap:
A Fisher-Minsky-Koo approach
Gauti B. Eggertsson (NY Fed) Paul Krugman (Princeton)
11/16/2010

In this paper we present a simple New Keynesian-style model of debt-driven slumps – that is, situations
in which an overhang of debt on the part of some agents, who are forced into rapid deleveraging, isdepressing aggregate demand. Making some agents debt-constrained is a surprisingly powerful
assumption: Fisherian debt deflation, the possibility of a liquidity trap, the paradox of thrift, a Keynesiantype multiplier, and a rationale for expansionary fiscal policy all emerge naturally from the model. We
argue that this approach sheds considerable light both on current economic difficulties and on historicalepisodes, including Japan’s lost decade (now in its 18th year) and the Great Depression itself.

This paper presents preliminary findings and is being distributed to economists
and other interested readers solely to stimulate discussion and elicit comments.
The views expressed in the paper are those of the authors and are not necessarilyreflective of views at the Federal Reserve Bank of New York or the Federal
Reserve System. Any errors or omissions are the responsibility of the authors.

Introduction

If there is a single word that appears most frequently in discussions of the economic problems
now afflicting both the United States and Europe, that word is surely “debt.” As Table 1 shows,there was a rapid increase in household debt in a number of countries in the years leading up to
the 2008 crisis; this debt, it’s widely argued, set the stage for the crisis, and the overhang of debt
continues to act as a drag on recovery. Debt is also invoked – wrongly, we’ll argue – as a reason
to dismiss calls for expansionary fiscal policy as a response to unemployment: you can’t solve a
problem created by debt by running up even more debt, say the critics.
The current preoccupation with debt harks back to a long tradition in economic analysis.
Irving Fisher (1933) famously argued that the Great Depression was caused by a vicious circle inwhich falling prices increased the real burden of debt, which led in turn to further deflation. The
late Hyman Minsky (1986), whose work is back in vogue thanks to recent events, argued for arecurring cycle of instability, in which calm periods for the economy lead to complacency about
debt and hence to rising leverage, which in turn paves the way for crisis. More recently, Richard
Koo (2008) has long argued that both Japan’s “lost decade” and the Great Depression were
essentially caused by balance-sheet distress, with large parts of the economy unable to spend
thanks to excessive debt.
There is also a strand of thinking in international monetary economics that stresses theimportance of debt, especially debt denominated in foreign currency. Krugman (1999), Aghion
et. al (2001) and others have suggested that “third-generation” currency crises – the devastating
combinations of drastic currency depreciation and severe real contraction that struck sucheconomies as Indonesia in 1998 and Argentina in 2002 – are largely the result of private-sector1indebtedness in foreign currency. Such indebtedness, it’s argued, exposes economies to a vicious
circle closely related to Fisherian debt deflation: a falling currency causes the domestic-currency
value of debts to soar, leading to economic weakness that in turn causes further depreciation.
Given both the prominence of debt in popular discussion of our current economic difficulties
and the long tradition of invoking debt as a key factor in major economic contractions, one might
have expected debt to be at the heart of most mainstream macroeconomic models– especially the
analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite
common to abstract altogether from this feature of the economy1. Even economists trying toanalyze the problems of monetary and fiscal policy at the zero lower bound – and yes, that
includes the authors (see e.g. Krugman 1998, Eggertsson and Woodford 2003) -- have often
adopted representative-agent models in which everyone is alike, and in which the shock thatpushes the economy into a situation in which even a zero interest rate isn’t low enough takes theform of a shift in everyone’s preferences. Now, this assumed preference shift can be viewed as aproxy for a more realistic but harder-to-model shock involving debt and forced deleveraging. But
as we’ll see, a model that is explicit about the distinction between debtors and creditors is much
more useful than a representative-agent model when it comes to making sense of current policy
debates.
Consider, for example, the anti-fiscal policy argument we’ve already mentioned, which isthat you can’t cure a problem created by too much debt by piling on even more debt. Households
borrowed too much, say many people; now you want the government to borrow even more?

1

Important exceptions include Bernanke and Gertler (1989) and Kiyotaki and Moore (1997).
Considerable literature has sprung from these papers, for a comprehensive review see Gertler andKiyotaki (2010). For another recent contribution that takes financial factors explicitly into account see,e.g., Curdia and Woodford (2009) and Christiano, Motto and Rostagno (2009).
2What's wrong with that argument? It assumes, implicitly, that debt is debt -- that it doesn't
matter who owes the money. Yet that can't be right; if it were, debt wouldn't be a problem in thefirst place. After all, to a first approximation debt is money we owe to ourselves -- yes, the US
has debt to China etc., but that's not at the heart of the problem. Ignoring the foreign component,or looking at the world as a whole, the overall level of debt makes no difference to aggregate net
worth -- one person's liability is another person's asset.
It follows that the level of debt matters only if the distribution of that debt matters, if highly
indebted players face different constraints from players with low debt. And this means that all
debt isn't created equal -- which is why borrowing by some actors now can help cure problems
created by excess borrowing by other actors in the past. In particular, deficit-financed
government spending can, at least in principle, allow the economy to avoid unemployment anddeflation while highly indebted private-sector agents repair their balance sheets.
This is, as we’ll see, just one example of the insights we can gain by explicitly putting private
debt in our model.
In what follows, we begin by setting out a flexible-price endowment model in which“impatient” agents borrow from “patient” agents, but are subject to a debt limit. If this debt limit
is, for some reason, suddenly reduced, the impatient agents are forced to cut spending; if therequired deleveraging is large enough, the result can easily be to push the economy up against
the zero lower bound. If debt takes the form of nominal obligations, Fisherian debt deflation
magnifies the effect of the initial shock.
We next turn to a sticky-price model in which the deleveraging shock affects output insteadof, or as well as, prices. In this model, a shock large enough to push the economy up against thezero lower bound also lands us in a world of topsy-turvy, in which many of the usual rules of3macroeconomics are stood on their head. The familiar but long-neglected paradox of thrift
emerges immediately; but there are other perverse results as well, including both the “paradox oftoil” (Eggertsson 2010b) – increasing potential output may reduce actual output – and the
proposition that increasing price flexibility makes the real effect of a debt shock worse, notbetter.
Finally, we turn to the role of monetary and fiscal policy, where we find, as already indicated,that more debt can be the solution to a debt-induced slump. We also point out a possibly
surprising implication of any story that attributes the slump to excess debt: precisely becausesome agents are debt-constrained, Ricardian equivalence breaks down, and old-fashioned
Keynesian-type multipliers in which current consumption depends on current income reemerge.

1. Debt and interest in an endowment economy

Imagine a pure endowment economy in which no aggregate saving or investment is possible,
but in which individuals can lend to or borrow from each other. Suppose, also, that while
individuals all receive the same endowments, they differ in their rates of time preference. In thatcase, “impatient” individuals will borrow from “patient” individuals. We will assume, however,that there is a limit on the amount of debt any individual can run up. Implicitly, we think of thislimit as being the result of some kind of incentive constraint; however, for the purposes of thispaper we take the debt limit as exogenous.
Specifically, assume for simplicity that there are only two representative agents, each ofwhom gets a constant endowment (1/2)Y each period. They have log utility functions:4

Where β(s)= β > β(b) – that is, the two types of individuals differ only in their rates of time
preference. We assume initially that borrowing and lending take the form of risk-free bonds
denominated in the consumption good. In that case the budget constraint of each agent isusing the notation that a positive D means debt, and a negative D means a positive asset holding.
Both agents need to respect a borrowing limit (inclusive of next period interest rate payments)
Dhigh so that at any date t

We assume that this bound is at least strictly lower than the present discounted value of output
of each agent, i.e. Dhigh < (1/2)(β/(1-β))Y. Because one agent (b) is more impatient than the other(s), the steady state solution of this model is one in which the impatient agent will borrow up to
his borrowing limit so that

where r is the steady state real interest rate. All production is consumed so that

Implying

Consumption of the saver satisfies a consumption Euler equation in each period:

implying that in the steady state the real interest rate is given by the discount factor of thepatient consumer so that5

2. The effects of a deleveraging shock

We have not tried to model the sources of the debt limit, nor will we try to in this paper.
Clearly, however, we should think of this limit as a proxy for general views about what level ofleverage on the part of borrowers is “safe”, posing an acceptable risk either of unintentional
default or of creating some kind of moral hazard.
The central idea of debt-centered accounts of economic instability, however, is that views
about safe levels of leverage are subject to change over time. An extended period of steadyeconomic growth and/or rising asset prices will encourage relaxed attitudes toward leverage. But
at some point this attitude is likely to change, perhaps abruptly – an event known variously as theWile E. Coyote moment or the Minksy moment.2

In our model, we can represent a Minsky moment as a fall in the debt limit from Dhigh to somelower level Dlow, which we can think of as corresponding to a sudden realization that assets were
overvalued and that peoples’ collateral constraints were too lax. In our flexible-price economy,
this downward revision of the debt limit will lead to a temporary fall in the real interest rate,
which corresponds to the natural rate of interest in the more general economy we’ll consider
shortly. As we’ll now see, a large enough fall in the debt limit will temporarily make the natural

2

For those not familiar with the classics, a recurrent event in Road Runner cartoons is the point when Wile E.
Coyote, having run several steps off a cliff, looks down. According to the laws of cartoon physics, it’s only when herealizes that nothing is supporting him that he falls. The phrase “Minsky moment” actually comes not from Minsky
himself but from Paul McCulley of Pimco, who also coined the term “shadow banking.”

6

rate of interest negative, an observation that goes to the heart of the economic problems wecurrently face.
Suppose, then, that the debt limit falls unexpectedly from Dhigh to Dlow. Suppose furthermorethat the debtor must move quickly to bring debt within the new, lower, limit, and must therefore"deleverage" to the new borrowing constraint. What happens?
To simplify, divide periods into in "short run" and "long run". Denote short run with S andlong run with L. Again, as in steady state, in the long run we have for the borrower

where we substituted for the long-run equilibrium real interest rate. In the short run, however, theborrower needs to deleverage to satisfy the new borrowing limit. Hence his budget constraint in
the short run is

Let’s assume that he must deleverage to the new debt limit within a single period. We are
well aware that this assumption sweeps a number of potentially important complications under
the rug, and will return to these complications at the end of the paper. For now, however,assuming that the borrower must deleverage within a single period to the new debt limit, we haveso his consumption is given by

The long run consumption of the saver is7Again recall that all production in the short run is consumed so that

Substituting for the consumption of the borrower we get

The optimal consumption decision of the saver satisfies the consumption Euler equation

Substitute the short and long run consumption of the saver into this expression and solve for
1+rS to obtain

Now all we need for a deleveraging shock to produce a potentially nasty liquidity trap is forthe natural rate of interest rS to go negative, i.e.

This condition will apply if βDhigh – Dlow is big enough, i.e. if the "debt overhang" is big enough.
The intuition is straightforward: the saver must be induced to make up for the reduction in8

consumption by the borrower. For this to happen the real interest rate must fall, and in the face ofa large deleveraging shock it must go negative to induce the saver to spend sufficiently more.
3. Determining the price level, without and with debt deflation
We have said nothing about the nominal price level so far. To make the price level
determinate, let's assume that there is a nominal government debt traded in zero supply so that
we also have an arbitrage equation that needs to be satisfied by the savers:

where Pt is the price level and it is the nominal interest rate. We need not explicitly introduce themoney supply; the results that follow will hold for a variety of approaches, including the"cashless limit" as in Woodford (2001), a cash-in-advance constraint as in Krugman (1998), anda money in the utility function approach as in Eggertsson and Wooford (2003)).
We impose the zero boundLet’s now follow Krugman (1998) and fix PL=P*, i.e. assume that after the deleveraging shock
has passed the zero bound will no longer be binding, and the price level will be stable; we canthink of this long-run price level as being determined either by monetary policy, as explained
below, or by an exogenously given money supply, as in Krugman (1998). Then we can see thatin the short run,If the zero bound weren’t a problem, it would be possible to set PS=P*. But if we solve for thenominal interest rate under the assumption that PS=P*, we get
9That is, maintaining a constant price level would require a negative nominal interest rate if
condition C1 is satisfied. This can’t happen; so if we substitute iS = 0 instead, and solve for the
price level, we get

As pointed out in Krugman (1998), then, if a shock pushes the natural rate of interest below
zero, the price level must drop now so that it can rise in the future, creating the inflationnecessary to achieve a negative real interest rate.
This analysis has assumed, however, that the debt behind the deleveraging shock is indexed,i.e., denominated in terms of the consumption good. But suppose instead that the debt is in
nominal terms, with a monetary value Bt. In that case, deflation in the short run will increase thereal value of the existing debt. Meanwhile, the debt limit is presumably defined in real terms,
since it’s ultimately motivated by the ability of the borrower to pay in the future out of his
endowment. So a fall in the price level will increase the burden of deleveraging. Specifically, if
debt is denominated in dollars, then Dhigh = Bhigh/PS, and the indebted agent must make short-run
repayments of

to satisfy the debt limit. Hence as the price level drops, he must pay more. Thus the natural rateof interest becomes

10

What this tells us is that the natural rate of interest is now endogenous: as the price level
drops, the natural rate of interest becomes more negative, thus making the price level drop evenmore, etc. This is simply the classic "Fisherian" debt deflation story.

4. Endogenous output
We now want to move to an economy in which production is endogenous. To do this we
assume that Ct now refers not to a single good, but instead is a Dixit-Stiglitz aggregate of acontinuum of goods giving the producer of each good market power with elasticity of demand
given by θ. Our representative consumers, thus have the following utility function

where now consumption refers to

index

and Pt is now the corresponding price. We also make a slight generalization of our previous setup. We

now assume that there is a continuum of consumers of measure 1, and that an arbitrary fraction χsof these consumers are savers and a fraction 1-χs are borrowers. Aggregate consumption is thus

where has the interpretation of being per capita consumption in the economy, while
capita savers’ consumption, andper capita borrowers’ consumption.

is perThere is a continuum of firms of measure one each of which produce one type of the varieties theconsumers like. We assume all firms have a production function that is linear in labor. Suppose11

a fraction 1-λ of these monopolistically competitive firms keep their prices fixed for a certain
planning period while the λ fraction of the firms can change their prices all the time. We assume
that the firms are committed to sell whatever is demanded at the price they set and thus have tohire labor to satisfy this demand.
In the Appendix we put all the pieces of this simple general equilibrium model together. Afterderiving all the equilibrium conditions, we approximate this system by a linear approximation
around the steady state of the model when.

The new main new element here is a "New Classical Phillips curve" of the following form:

where

and the parameteris defined in the appendix, whileand. The key point is that output is no longer an exogenous endowment as in our last
example. Instead, if inflation is different in the short run from what those firms that preset prices
expected, then output will be above potential.
We now are also a bit more specific about how monetary policy is set. In particular we assume
that the central bank follows a Taylor rule of the following form:

where

and

is the natural rate of interest (defined below).

The rest of the model is the same as we have already studied, with minor adjustments due to theway in which we have normalized our economy in terms of per capita consumption of eachgroup. Linearizing the consumption Euler equation of savers gives

12where,and. Linearizing the resource constraint yields

where

, and

now refers to log(1+ ) in terms of our previous notation. To close the model, it now remains to determine the consumption behaviorof the borrowers, which is again at the heart of the action. To simplify exposition, again, let us
split the model into "short run" and "long run" with an unexpected shock occurring in the shortrun. We can then see immediately from the AS equation thatso that the economy willrevert back to its "flexible price" equilibrium in the long run as this model has long run
neutrality. The model will then, with one caveat, behave exactly like the flexible price model wejust analyzed. We have already seen that in the long run
rule implies a unique bounded solution for the long run in which. Also note that the policy
and.

Again, then, all the action is in the short run. The caveat here involves the determination of thelong-run price level. Given the Taylor rule we have just specified, prices will not revert to someexogenously given P*. Instead, they will be stabilized after the initial shock, so that prices willremain permanently at the short-run equilibrium level PS. It would be possible to write a different
Taylor rule that implies price level reversion; as we’ll see shortly, the absence of price level
reversion matters for the slope of the aggregate demand curve.
Back to the model: in the short run, the borrower once again needs to deleverage to satisfy hisborrowing limit. His consumption is thus given by

where

,

.

13

Note that this is a “consumption function” in which current consumption is in part determinedby current income (recall that in our current notation

is output per capita in percentage

deviation from steady state)– not, as has become standard in theoretical macroeconomics, solely
by expectations of future income. The explanation is simple: by assumption, the borrower isliquidity-constrained, unable to borrow and paying down no more debt than he must. In fact, themarginal propensity to consume out of current income on the part of borrowers is 1.
Meanwhile, the saver’s consumption is given by

Substitute this into the resource constraint to obtainoror

where in the second two lines we have used

and last line we have used thedefinition of the natural rate of interest (i.e. the real interest rate if prices were fully flexible)
which is given by

What does the Equation in (2) and (3) mean? It’s an IS curve, a relationship between the interest
rate and total demand for goods. And the underlying logic is very similar to that of the oldfashioned Keynesian IS curve. Consider what happens if iS falls, other things equal. First, savers

14

are induced to consume more than they otherwise would. Second, this higher consumption leads
to higher income for both borrowers and savers. And because borrowers are liquidityconstrained, they spend their additional income, which leads to a second round of income
expansion, and so on.
Once we combine this derived IS curve with the assumed Taylor rule, it’s immediately clearthat there are two possible regimes following a deleveraging shock. If the shock is relatively
small, so that the natural rate of interest remains positive, the actual interest rate will fall to offset
any impact on output. If the shock is sufficiently large, however, the zero lower bound will bebinding, and output will fall below potential.
The extent of this fall depends on the aggregate supply response, because any fall in output
will also be associated with a fall in the price level, and the natural rate of interest is endogenous
thanks to the Fisher effect. Since the deleveraging shock is assumed to be unanticipated, so that, the aggregate supply curve may be written

Substituting this into the equation above, and assuming the shock to D is large enough so that thezero bound is binding, we obtain

where

3

So the larger the debt shock, the larger both the fall in output and the fall in theprice level. But the really striking implications of this model come when one recasts it in termsof a familiar framework, that of aggregate supply and aggregate demand. The basic picture is
3

Where

15

shown in Figure 1. The short-run aggregate supply curve is, as we’ve already seen, upward
sloping. The surprise, however, is the aggregate demand curve: in the aftermath of a large
deleveraging shock, which puts the economy up against the zero lower bound, it is also upward
sloping – or, if you prefer, backward bending.4

The reason for this seemingly perverse slope

should be obvious from the preceding exposition: because a lower price level increases the realvalue of debt, it forces borrowers to consume less; meanwhile, savers have no incentive toconsume more, because the interest rate is stuck at zero.
We next turn to the seemingly paradoxical implications of a backward-sloping AD curve forsome key macroeconomic issues.

5. Topsy-turvy: Paradoxes of thrift, toil, and flexibility
The paradox of thrift is a familiar proposition from old-fashioned Keynesian economics: if
interest rates are up against the zero lower bound, a collective attempt to save more will simply
depress the economy, leading to lower investment and hence (through the accounting identity) tolower savings. Strictly speaking, our model cannot reproduce this paradox, since it’s a pureconsumption model without investment. However, it does give a plausible mechanism throughwhich the economy can find itself up against the zero lower bound. So this model is, in spirit if
not precisely in letter, a model of a paradox-of-thrift type world.5
Beyond this, there are two less familiar paradoxes that pop up thanks to the backward-sloping
AD curve.
4

We assume that the AD curve, while backward-sloping, remains steeper than the AS curve. Otherwise the shortrun equilibrium will be unstable under any plausible adjustment process. This amounts to the assumption that
. Note that ifthen the AD is vertical. As we increase the number of constrained people it
starts sloping backwards, eventually so far that the AS and AD become closed to parallel, the model explodes, andour approximation is no longer valid. Our assumption guarantees that this is not the case.
5
See Eggertsson (2010b) for an explicit example of how the paradox occurs with endogenous investment but
through preference shocks which also show up as a decline in the natural rate of interest.

16

First is the “paradox of toil,” first identified by Eggertsson (2010b), but appearing here in astarker, simpler form than in the original exposition, where it depended on expectational effects.
Suppose that aggregate supply shifts out, for whatever reason – a rise in willingness to work, achange in tax rates inducing more work effort, a rise in productivity, whatever. As shown in
Figure 2, this shifts the aggregate supply curve AS to the right, which would ordinarily translate
into higher actual output. But the rise in aggregate supply leads to a fall in prices – and in theface of a backward-sloping AD curve, this price decline is contractionary via the Fisher effect.
So more willingness and/or ability to work ends up reducing the amount of work being done.
Second, and of considerable relevance to the ongoing economic debate, is what we will term
the “paradox of flexibility.”
It is commonly argued that price and wage flexibility helps minimize the losses from adverse
demand shocks. Thus Hamilton (2007), discussing the Great Depression, argues that “What is
supposed to help the economy recover is that a substantial pool of unemployed workers should
result in a fall in wages and prices that would restore equilibrium in the labor market, as long as
the government just keeps the money supply from falling.” The usual criticism of New Deal
policies is that they inhibited wage and price flexibility, thus blocking recovery.
Our model suggests, however, that when the economy is faced by a large deleveraging
shock, increased price flexibility – which we can represent as a steeper aggregate supply curve –actually makes things worse, not better. Figure 3 illustrates the point. The shock is represented asa leftward shift in the AD curve from AD1 to AD2; we compare the effects of this shock in theface of a flat AS curve ASsticky, corresponding to inflexible wages and prices, and a steeper AS
curve ASflexible, corresponding to more responsive wages and prices. The output decline in thelatter case is larger, not smaller, than in the former. Why? Because falling prices don’t help raise17

demand, they simply intensify the Fisher effect, raising the real value of debt and depressing
spending by debtors.6

6. Monetary and fiscal policy
What can policy do to avoid or limit output loss in the face of a deleveraging crisis? Ourmodel has little new to say on the monetary front, but it offers some new insights into fiscal
policy.
On monetary policy: as pointed out by Krugman (1998) and reiterated in part 1 of this paper,
expected inflation is the “natural” solution to a deleveraging shock, in the sense that it’s how theeconomy can achieve the negative natural real interest rate even though nominal rates arebounded at zero. In a world of perfect price flexibility, deflation would “work” under liquidity
trap conditions, if it does, only by reducing the current price level relative to the expected future
price level, thereby generating expected inflation. It’s therefore natural, in multiple senses, tothink that monetary policy can deal with a deleveraging shock by generating the necessary rise in
expected inflation directly, without the need to go through deflation first.
In the context of the model, this rise in expected inflation could be accomplished by changing
the Taylor rule; this would amount to the central bank adopting, at least temporarily, a higher
inflation target. As is well understood, however, this would only work if the higher target iscredible – that is, if agents expect the central bank to follow through with promises of higher
inflation even after the deleveraging crisis has passed. Achieving such credibility isn’t easy,
since central bankers normally see themselves as defenders against rather than promoters of

6

As similar paradox is documented in Eggertsson (2010b) but unlike here, there it relies on an expectation
channel.

18

inflation, and might reasonably be expected to revert to type at the first opportunity. So there is atime consistency problem.
Where this model adds something to previous analysis on monetary policy is what it has tosay about an incomplete expansion – that is, one that reduces the real interest rate, but notenough to restore full employment. The lesson of this model is that even such an incomplete
response will do more good than a model without debt suggests, because even a limited
expansion leads to a higher price level than would happen otherwise, and therefore to a lower
real debt burden.
Where the model really suggests new insights, however, is on fiscal policy.
It is a familiar proposition, albeit one that is strangely controversial even within themacroeconomics community, that a temporary rise in government purchases of goods andservices will increase output when the economy is up against the zero lower bound; Woodford(2010) offers a comprehensive account of what representative-agent models have to say on thesubject. Contrary to widely held belief, Ricardian equivalence, in which consumers take into
account the future tax liabilities created by current spending, does not undermine this
proposition. In fact, if the spending rise is limited to the period when the zero lower bound isbinding, the rise in income created by that spending fully offsets the rise in future taxes; themultiplier on government spending in a simple one period liquidity trap consumption-only model
like the one considered here, but without debt, ends up being exactly one (once multiple periods
are studied, and expectations taken into account, this number can be much larger, especially at
the zero bound as for example shown in Christiano et al (2009) and Eggertsson (2010a))19What does modeling the liquidity trap as the result of a deleveraging shock add? First, it
gives us a reason to view the liquidity trap as temporary, with normal conditions returning once
debt has been paid down to the new maximum. This in turn explains why more (public) debt canbe a solution to a problem caused by too much (private) debt. The purpose of fiscal expansion isto sustain output and employment while private balance sheets are repaired, and the government
can pay down its own debt after the deleveraging period has come to an end.
Beyond this, viewing the shock as a case of forced deleveraging suggests that fiscal policy
will, in fact, be more effective than standard models suggest – because Ricardian equivalence
will not, in fact, hold. The essence of the problem is that debtors are liquidity-constrained, forced
to pay down debt; this means, as we have already seen, that their spending depends at the margin
on current income, not expected future income, and this means that something resembling oldfashioned Keynesian multiplier analysis reemerges even in the face of forward-looking behavior
on the part of consumers.7
Let us revise the model slightly to incorporate government purchases of goods and services,on one side, and taxes, on the other. We assume that the government purchases the same
composite good consumed by individuals, but uses that good in a way that, while it may provide
utility to consumers, is separable from private consumption and therefore does not affectintertemporal choices. We also assume that taxation takes a lump-sum form. The budget
constraint for borrowers may now be written

while the savers’ consumption Euler equation remains the same.
7

The closest parallel to our debt-constraint consumers in studies of fiscal policy in New Keynesian models are the“rule-of-thumb” consumers in Gali, Lopez-Salido and Valles (2007). In their work a fraction of workers spend alltheir income (because of rules of thumb or because they do not have access to financial markets). This gives rise toa multiplier of a similar form as we study here since in their model aggregate spending also depends in part
directly on income as in old Keynesian models.

20

The AS equation is now

The resource constraint is now given by

Substituting the AS equation into the consumption function of the borrower, and substituting theresulting solution into the resource constraint, together with the consumption of the saver, andsolving for output, we obtain an expression for output as a function of the fiscal instruments:

To understand this result, it’s helpful to focus first on a special case, that of a horizontal
short-run aggregate supply curve, i.e., κ=0.8 In that case the third term simplifies toThis says that a temporary rise in government spending has a multiplier greater than one, withthe size of that multiplier depending positively on the share of debt-constrained borrowers in theeconomy. If constrained borrowers receive one-third of income, for example, the multiplierwould be 1.5; if they receive half of income, it would be 2, and so on.
If we now reintroduce an upward-sloping aggregate supply curve, so that κ>0, the multiplieris affected by two forces. First, the fiscal expansion has the additional effect of raising the pricelevel above what it would have been otherwise, and hence reducing the real debt burden. Second,
the increase in spending increases aggregate supply9, which works in the opposite direction due
to the paradox of toil. By taking a partial derivative of the multiplier with respect to κ we can8

In this case we abstract from the “Fisher effect” of inflation reducing real debt and thus creating more expansion,
but we also abstract from the fact that an increase in government spending increases AS which works in the
opposite direction due to the paradox of toil.
9
As it makes people work more due to an increase in the marginal utility of private consumption.

21

see that the first effect will always dominate, so that the multiplier is increasing in κ . Overall thismodel suggests a relatively favorable view of the effectiveness of fiscal policy after adeleveraging shock.
Also note the middle term: in this model tax cuts and transfer payments are effective inraising aggregate demand, as long as they fall on debt-constrained agents. In practice, of course,
it’s presumably impossible to target such cuts entirely on the debt-constrained, so the oldfashioned notion that government spending gets more bang for the buck than taxes or transfers
survives. And the model also suggests that if tax cuts are the tool chosen, it matters greatly who
receives them.
The bottom line, then, is that if we view liquidity-trap conditions as being the result of adeleveraging shock, the case for expansionary policies, especially expansionary fiscal policies, issubstantially reinforced. In particular, a strong fiscal response not only limits the output loss
from a deleveraging shock; it also, by staving off Fisherian debt deflation, limits the size of theshock itself.

Conclusions

In this paper we have sought to formalize the notion of a deleveraging crisis, in which there
is an abrupt downward revision of views about how much debt it is safe for individual agents tohave, and in which this revision of views forces highly indebted agents to reduce their spending
sharply. Such a sudden shift to deleveraging can, if it is large enough, create major problems ofmacroeconomic management. For if a slump is to be avoided, someone must spend more to22

compensate for the fact that debtors are spending less; yet even a zero nominal interest rate may
not be low enough to induce the needed spending.
Formalizing this concept integrates several important strands in economic thought. Fisher’s
famous idea of debt deflation emerges naturally, while the deleveraging shock can be seen as our
version of the increasingly popular notion of a “Minsky moment.” And the process of recovery,
which depends on debtors paying down their liabilities, corresponds quite closely to Koo’s
notion of a protracted “balance sheet recession.”
One thing that is especially clear from the analysis is the likelihood that policy discussion in
the aftermath of a deleveraging shock will be even more confused than usual, at least viewed
through the lens of the model. Why? Because the shock pushes us into a world of topsy-turvy, inwhich saving is a vice, increased productivity can reduce output, and flexible wages increase
unemployment. However, expansionary fiscal policy should be effective, in part because themacroeconomic effects of a deleveraging shock are inherently temporary, so the fiscal response
need be only temporary as well. And the model suggests that a temporary rise in government
spending not only won’t crowd out private spending, it will lead to increased spending on thepart of liquidity-constrained debtors.
The major limitation of this analysis, as we see it, is its reliance on strategically crude
dynamics. To simplify the analysis, we think of all the action as taking place within a single,
aggregated short run, with debt paid down to sustainable levels and prices returned to full ex ante
flexibility by the time the next period begins. This sidesteps the important question of just how
fast debtors are required to deleverage; it also rules out any consideration of the effects ofchanges in inflation expectations during the period when the zero lower bound remains binding,23

a major theme of recent work by Eggertsson (2010a), Christiano et. al. (2009), and others. In
future work we hope to get more realistic about the dynamics.
We do believe, however, that even the present version sheds considerable light on the
problems presently faced by major advanced economies. And yes, it does suggest that the current
conventional wisdom about what policy makers should be doing now is almost completely
wrong.
References
Aghion, P., Bachetta, P. and Banerjee, A. (2001), “Currency Crises and Monetary Policy in an
EconomyWith Credit Constraints,” European Economic Review, vol. 45, issue 7.
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Christiano, Lawrence, Martin Eichenbaum, and Sergio Rebelo (2009). "When Is the Government
Spending Multiplier Large," Northerwestern, NBER Working Paper.
Christiano, Lawrence, Roberto Motto and Massimo Rostagno, 2009, "Financial
Factors in Business Fluctuations," mimeo, Northwestern University.
Eggertsson, Gauti and Woodford, Michael (2003), "The Zero Bound on Interest Rates andOptimal Monetary Policy," Brookings Papers on Economic Activity 1, 212-219.
Eggertsson, Gauti, (2010a), “What fiscal policy is effective at zero interest rates?”, NBER
Macroeconomic Annual 2010.
Eggertsson, Gauti, (2010b) “The Paradox of Toil,” Federal Reserve Bank of New York Staff
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no. 4.

24

Gali, J. J.D. Lopes-Salido and J. Valles (2007), ““Understanding the Effects of Government
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Koo, Richard (2008), The Holy Grail of Macroeconomics: Lessons from Japan’s GreatRecession, Wiley.
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Brookings Papers on Economic Activity 2:1998.
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McKinsey Global Institute (2010), Debt and Deleveraging: The Global Credit Bubble and its
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NBER Working Paper # 15714.

25

Table 1: Household debt as % of disposable personal income

2000

2008

US

96

128

UK

105

160

Spain

69

130

Source: McKinsey Global Institute (2010)

26

27

Appendix
This appendix summarizes the micro foundations of the simple general equilibrium modelstudied in the paper and shows how we obtain the log-linear approximations stated in the text (atextbook treatment of a similar model with the same pricing frictions is found in Woodford(2003), Chapter 3).
A.1. Households
There is a continuum of households of mass
problem is to maximize

where

with

of type andof type . Theiror , s.t.

,
where is the nominal interest rate that is the return on one period riskfree nominal bond, whileis the riskfree real interest rate on a one period real bond. We derive the first order conditionsof this problem by maximizing the LagrangianFirst order conditions

28

Complementary slackness condition

The

and

above refers to the Dixit-Stiglitz aggregatorto the corresponding price index

The household maximization problem implies an aggregate demand function of good given by

A.2 Firms
There is a continuum of firms of measure one with a fraction the sets prices freely at all times
and a fractionthat set their prices one period in advance.
. We define theaverage marginal utility of income as. Firms maximize profits overthe infinite horizon using
to discount profits (this assumption plays no role in our log-linear
economy but is stated for completeness):s.t.

From this problem, we can see that thethey set their price so thatfraction of firms that set their price freely at all times

29and each charging the same pricehowever, satisfy. Those that set their price one period in advance,

A.3 Government
Fiscal policy is the purchase of of the Dixit-Stiglitz aggregate and the collects taxes
and. For any variations inor we assume that current or future
will be adjusted to satisfy
the government budget constraint. Monetary policy is the choice of . We assume it follows the
Taylor rule specified in the text.
A.4 Log linear approximation
Aggregate consumption is
,
where

and

is the of the consumption levels of each type. Similarly aggregate hours are,while aggregate output is given

We consider a steady state of the model in whichinflation is at zero (i.e.

) andborrows up to its limit, while the does not,

while

.

Let’s start with linearizing the demand side. Observe that if we aggregate wage and profits for
type , i.e. sum over

for all , we obtain. Assuming typeup against his borrowing constraint and aggregating over all types we obtain

Log-linearizing this around

we obtain.

where
notation,

,
,

,

,
,

is now,

For type we obtain30

in our previous.

isand log-linearizing this around steady state yields
,
where

and

. Aggregate consumption is then
,

where

and
,

where

,

Let us now turn to the production side. The pricing equations of the firms imply

where

,

, and

which implies that

Log-linearizing the aggregate price index, implies

so it follows that

To solve forto yieldwhere

we linearize each of the optimal labor supply first order condition for each type

,

and

,

.
31

, and

and

Observe that

. We now assume thatand that. Using this we can now combine the labor supply of the two types to yield.

Combine this with our previous result, together with

where

.

32

to yield