Is Debt Overhang a Problem for Monetary Policy?

The U.S economy has accumulated in recent years seemingly excessive levels of household debt. U.S monetary policy has responded to the situation by keeping real interest rates low. Critics of the low real interest rate policy contend that such a policy helps borrowers and punishes savers, thus delaying the necessary adjustment needed to return to balanced growth. We consider a macroeconomic setting which gives voice to these concerns. In the model, lifecycle considerations lead to a natural interaction between young borrowers and middle-aged lenders. Optimism concerning future income prospects will raise borrowing, but if the optimism later turns out to be unwarranted, households will have borrowed too much. We show that, in this setting, overhang drives real interest rates up, not down, and that policy attempts to keep rates lower may drag out the necessary adjustment to the balanced growth path, and lower lifecycle welfare. We compare these findings to recent contributions on debt overhang emphasizing exogenous debt constraints due to Eggertsson and Krugman(2010) and Guerrierri and Lorenzoni(2010).