At the beginning of the current century, in the public debate on problems of the world economy, ‘deflation’ or more specifically ‘debt deflation’ has once again become an important topic. The possible role of debt deflation in triggering the Great Depression of the 1930s has long been the subject of academic studies. It has been observed that there are similarities between recent global trends and the 1930s, namely the joint occurrence of high levels of debt and falling prices: the dangerous downside to cheaper credit when debt is high. Debt deflation thus concerns the interaction of high nominal debt of firms, households and nations and shrinking economic activity due to falling output prices and therefore increasing real debt.
There is often another mechanism accompanying the first one. That other mechanism deals with how large debt may exert its impact on macroeconomic activity, and works through the asset market. Asset price inflation during economic expansions normally gives rise to generous credit extension and lending booms. Assets with inflated prices serve as collateral for borrowing by firms, households or nations. On the other hand when asset prices fall the borrowing capacity of economic agents shrinks, financial failures may set in, macroeconomic activity decreases and consequently large output losses may occur.
Countries that have gone through such booms and busts are Asian countries, in particular Japan, as well as Russia and Brazil in the years 1998 and 1999.
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