Leverage as a State Variable for Employment, Inventory Accumulation and Fixed Investment

Abstract

’Debt-deflation’ refers to one of the ways in which the cumulative past of the economy matters for its future evolution. In a debt-deflation, existing debt contracts become a burden on producers. consumers, or intermediaries, and prevent them from achieving levels of activity that they otherwise would have achieved had their earlier contracting decisions been different. Adverse shocks to real income or a lower than anticipated price level effectively raise the burclen or value of debt relative to equity, and the amount of debt payments relative to cash flow, which in turn reduce agents’ credit-worthiness and force them to limit their activities. As Keynes ( 1931) and Fisher (1933) argued, debt-deflations that constrain expenditures of firms and individuals, as well as lending by intermediaries, can produce debt-deflation spirals of ever-worsening economic conditions. Much research on the Great Depression and other historical depressions has focused on debt-deflation as one of the ways in which shocks to demand produced persistent declines in aggregate economic activity by undermining the credit-worthiness of borrowers and banks (Mishkin, 1978; Hunter, 1982; Bernanke, 1983; Eichengreen and Sachs, 1985, 1986; Calomiris and Hubbard, 1989; Temin, 1989; Bernanke and James, 1991; Calomiris, 1993).

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