We propose a theory of indebted demand, capturing the idea that large debt burdens by households and governments lower aggregate demand, and thus natural interest rates. At the core of the theory is the simple yet under-appreciated observation that borrowers and savers differ in their marginal propensities to save out of permanent income. Embedding this insight in a two-agent overlapping-generations model, we find that recent trends in income inequality and financial liberalization lead to indebted household demand, pushing down natural interest rates. Moreover, popular expansionary policies—such as accommodative monetary policy and deficit spending—generate a debt-financed short-run boom at the expense of indebted demand in the future. When demand is sufficiently indebted, the economy gets stuck in a debt-driven liquidity trap, or debt trap. Escaping a debt trap requires consideration of less standard macroeconomic policies, such as those focused on redistribution or those reducing the structural sources of high inequality.
We thank George-Marios Angeletos, Heather Boushey, Fatih Guvenen, Gerhard Illing, Ernest Liu, Fabrizio Perri, Andrei Shleifer, Alp Simsek, Jeremy Stein, Larry Summers, and Ivan Werning as well as seminar participants at Harvard, Princeton, Chicago Booth, Stanford, UCLA, Bocconi, LMU, ECB, and Banque de France for numerous useful comments. Sebastian Hanson, Bianca He, Julio Roll, and Ian Sapollnik provided excellent research assistance. Straub appreciates support from the Molly and Domenic Ferrante Award. Contact info: Mian: (609) 258 6718, firstname.lastname@example.org; Straub: (617) 496 9188, email@example.com; Sufi: (773) 702 6148, firstname.lastname@example.org. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.