Indebted Demand

BIS Working Papers  |  No 968  | 
19 October 2021



Rising debt and falling interest rates have characterised advanced economies over the past 40 years. The average real interest rate dropped from 6% in 1980 to less than zero in 2019. Meanwhile, the average debt to GDP ratio almost doubled from 139% in 1980 to over 270% in 2019. The economic fallout of the Covid-19 health crisis is likely to accelerate these patterns going forward, as governments pursue aggressive debt-financed stimulus policies. The objective of this paper is to understand how the twin phenomena of high debt and low interest rates came to be.


This paper explains the concomitant rise in debt and fall in interest rates by the liberalisation of the financial sector and income inequality. When rich households get richer, they tend to lend to poor ones. Given that poor households have relatively higher marginal propensities to consume, large debt levels weigh negatively on aggregate demand. As borrowers reduce their spending to make debt payments to savers, the latter – having greater saving rates – only imperfectly offset the shortfall in borrowers' spending. Such a situation, in which demand is depressed due to elevated debt levels, is called "indebted demand".


The concept of indebted demand has broad implications for evaluating which policies can potentially help advanced economies to escape the current high-debt and low-rate environment. An important finding of the paper is that policies that boost demand today through debt accumulation necessarily reduce demand going forward by shifting resources from borrowers to savers. Therefore, such policies contribute to persistently low interest rates.


We propose a theory of indebted demand, capturing the idea that large debt burdens lower aggregate demand, and thus the natural rate of interest. At the core of the theory is the simple yet under-appreciated observation that borrowers and savers differ in their marginal propensities to save out of permanent income. Embedding this insight in a two-agent perpetual youth model, we find that recent trends in income inequality and financial deregulation lead to indebted household demand, pushing down the natural rate of interest. Moreover, popular expansionary policies-such as accommodative monetary policy-generate a debt-financed short-run boom at the expense of indebted demand in the future. When demand is sufficiently indebted, the economy gets stuck in a debt-driven liquidity trap, or debt trap. Escaping a debt trap requires consideration of less conventional macroeconomic policies, such as those focused on redistribution or those reducing the structural sources of high inequality.

Keywords: Indebted demand, inequality, debt, low rates, financial liberalisation

JEL classification: E21, E44, E6