Price Flexibility and Debt Dynamics in a High Order AS-AD Model

Abstract

In this paper we reconsider extensions and modifications of earlier work on a disequilibrium model of AS-AD growth. Our dynamic model exhibits more or less sluggishly adjusting prices and quantities, Keynesian demand rationing and fluctuating capacity utilization for both labor and capital. Firms use debt (and pure profits) to finance their investment expenditures. We first prove that the resulting 7D core dynamics are convergent (broadly speaking) for low adjustment speeds. We then demonstrate partly analytically and partly numerically that their interior steady state will lose asymptotic stability by way of Hopf bifurcations when relevant adjustment speeds are made sufficiently large. This holds in particular for debt deflation, where falling price levels (caused by price flexibility that is sufficiently high) cause significantly increasing real debt, falling investment and shrinking economic activity. This deepens the deflationary process already under way. Such an instability result even occurs in the case where accompanying real wage increases would support economic stability.