Chapter

The Debt Effect

Rohit

in It's Not Over

Published in print January 2013 | ISBN: 9780198088417
Published online January 2013 | e-ISBN: 9780199082292 | DOI: http://dx.doi.org/10.1093/acprof:oso/9780198088417.003.0006
The Debt Effect

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Chapter 6 studies the path of an economy where consumption of the workers is not limited by their wage income. They can take debt to finance it. Allowing for debt-driven consumption of the workers further adds to the counteracting tendency towards stagnation. Now that they can relax their budget constraint, the consumption of the workers might increase, instead of decreasing, thereby, giving rise to a boom. Short run dynamics show this process can produce a business cycle which moves according to the debt cycle. Tendency towards underconsumption can be overcome when the debt is increasing. Reverse would happen when defaults start happening as was evident in the subprime crisis. As was the case with the wealth effect, the debt effect has the potential of only generating a cycle instead of a prolonged growth, an experience borne out by the current crisis.

Keywords: workers’ debt; subprime crisis; budget constraint; housing bubble; debt-driven consumption

Chapter.  7415 words.  Illustrated.

Subjects: Macroeconomics and Monetary Economics

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