Debt Deleveraging and the Zero Bound: Potentially Perverse Effects of Real Exchange Rate Movements

We present a microfounded two-country model of global imbalances and debt deleveraging. A sustained rise in saving in one country can lead to a worldwide fall in interest rates and an accumulation of debt in the other country. When a subsequent deleveraging shock occurs, interest rates are forced down further. In the presence of a zero bound to interest rates, the deleveraging country may face a combination of a large fall in output, deflation, a rise in real interest rates and real exchange rate appreciation. Such exchange rate appreciation will intensify the loss in output, magnify the deflation and further tighten the deleveraging constraint.