This paper proposes a model of how agents adjust their asset holdings in
response to losses in general equilibrium. By emphasising the relation between
deflation and financial distress, we capture some original features of the
early debt-deflation literature, such as distress selling, instability, and
endogenous monetary contraction.
The agents affected by a shock sell off assets to prevent their debt from
crowding out consumption. But their distress-selling causes a decline in
equilibrium prices, and the resulting losses elicit reactions by all agents.
This activates several channels of debt-deflation. Yet we show that this
process remains stable, even in the presence of large shocks, high
indebtedness, and wide-spread default. What keeps the asset market stable is
the presence of agents without prior debt or losses, who borrow to exploit the
expected asset price recovery. By contrast, debt-deflation becomes unstable
when agents try to contain their indebtedness, or when a credit crunch
interferes with the accommodation necessary for stability.
JEL Classification: E31, E51, G33, G21, G18.
Keywords: Debt-Deflation, Leverage, Refinancing, Losses, Financial Distress,
Distress Selling, Asset Prices, Credit, Inside Money.