International debt deleveraging

I provide a framework for understanding debt deleveraging in a group of financiallyintegrated countries. During an episode of international deleveraging world consumptiondemand is depressed and the world interest rate is low, reflecting a high propensity to save.If exchange rates are allowed to float, deleveraging countries can depreciate their nominalexchange rate to increase production and mitigate the fall in consumption associatedwith debt reduction. The key insight of the paper is that in a monetary union thischannel of adjustment is shut off, and therefore the falls in consumption demand and inthe world interest rate are amplified. Hence, monetary unions are especially prone tohit the zero lower bound on the nominal interest rate and enter a liquidity trap duringdeleveraging. In a liquidity trap deleveraging gives rise to a union-wide recession, which isparticularly severe in high-debt countries. The model suggests several policy interventionsthat mitigate the negative impact of deleveraging on output in monetary unions.