We investigate the role of debt market policies in mitigating liquidity traps driven by household leverage. When borrowers engage in deleveraging, the interest rate needs to fall to induce lenders to pick up the decline in aggregate demand. However, if the fall in the interest rate is limited by the zero lower bound, aggregate demand is insufficient and the economy enters a liquidity trap. In such an environment, households' borrowing and saving decisions are associated with aggregate demand externalities. The competitive equilibrium allocation is constrained inefficient. Welfare can be improved by ex-ante restrictions on leverage to mitigate prospective deleveraging. Ex-post policies to write down debt also generate positive demand externalities.
