We propose a theory of indebted demand, capturing the idea that large debt burdens lower aggregate demand, and thus the natural rate of interest. At the core of the theory is the simple yet underappreciated observation that borrowers and savers differ in their marginal propensities to save out of permanent income. Embedding this insight in a two-agent perpetual-youth model, we find that recent trends in income inequality and financial deregulation lead to indebted household demand, pushing down the natural rate of interest. Moreover, popular expansionary policies—such as accommodative monetary policy—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 conventional macroeconomic policies, such as those focused on redistribution or those reducing the structural sources of high inequality.

We study a real small open economy with two key ingredients (1) partial segmentation of home and foreign bond markets and (2) a pecuniary externality that makes the real exchange rate excessively volatile in response to capital flows. Partial segmentation implies that, by intervening in the bond markets, the central bank can affect the exchange rate and the spread between home- and foreign-bond yields. Such interventions allow the central bank to address the pecuniary externality, but they are also costly, as foreigners make carry trade profits. We analytically characterize the optimal intervention policy that solves this trade-off: (1) the optimal policy leans against the wind, stabilizing the exchange rate; (2) it involves smooth spreads but allows exchange rates to jump; (3) it partly relies on “forward guidance,” with non-zero interventions even after the shock has subsided; (4) it requires credibility, in that central banks do not intervene without commitment. Finally, we shed light on the global consequences of widespread interventions, using a multi-country extension of our model. We find that, left to themselves, countries over-accumulate reserves, reducing welfare and leading to inefficiently low world interest rates.

We propose a general and highly efficient method for solving and estimating general equilibrium heterogeneous‐agent models with aggregate shocks in discrete time. Our approach relies on the rapid computation of sequence‐space Jacobians —the derivatives of perfect‐foresight equilibrium mappings between aggregate sequences around the steady state. Our main contribution is a fast algorithm for calculating Jacobians for a large class of heterogeneous‐agent problems. We combine this algorithm with a systematic approach to composing and inverting Jacobians to solve for general equilibrium impulse responses. We obtain a rapid procedure for likelihood‐based estimation and computation of nonlinear perfect‐foresight transitions. We apply our methods to three canonical heterogeneous‐agent models: a neoclassical model, a New Keynesian model with one asset, and a New Keynesian model with two assets.