High Leverage and a Great Recession

This paper examines the role of high leverage, deleveraging, and the zero lower bound on nominal interest rates (ZLB) in explaining macroeconomic and housing price uctuations under an adverse credit shock. There are two key features that dierentiate my work from the existing literature of deleveraging and the ZLB. First, I endogenize the debt limit of borrowers by tying it to the market value of collateral assets and credit market conditions. Second, I allow for high leverage by calibrating the model to match with the high debt-to-income ratio in the U.S. at the onset of the Great Recession. I am able to show that, only with the second feature, the ZLB is more likely to bind under an adverse credit shock, compared to the model with exogenous debt limits by Eggertsson and Krugman [2012]. When the ZLB binds, a great recession emerges with a drastic decline in output and the price level, mainly due to the Fisherian debt deation that puts more debt burden