The Balance Sheet Recession: can a deleveraging shock change the agents' behaviour?

As described by Richard Koo, a Balance Sheet Recession occurs when a debt bubble bursts leading to a dramatic fall in asset prices. The private sector, which has previously accumulated high level of debt in order to fund investments (according to the ¿Financial Instability Hypothesis¿ by Hyman Minsky), faces a liquidity problem and tries to repair its balance sheet by paying down its debts ¿ that is, it's deleveraging. This distress selling can lead to a fall in prices and, in turn, to a higher level of real debt. This worsens the balance sheets of agents, in a vicious circle which Irving Fisher has called ¿Debt-Deflation¿, starting a potential financial crisis. This thesis is a first attempt to build a simple, coherent micro-founded model emboying some aspects of Koo's theory, first of all the new priority agents. In a dynamic, general equilibrium context with financial imperfections we study the interaction between a credit shock and the pre-accumulated debt level and look for a numerical solution. We also consider the Impulse Response Function of the main variables following a dramatic drop in asset prices.