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Highlights: [•] This paper presents a model of financial instability with household debt. [•] Household debt interacts with functional income distribution and credit supply. [•] Financial fragility arises through a Fisher effect in the first case. [•] Instability arises through a debt financed consumption boom in the second case. [•] The model also looks at debt default and capital adequacy ratio. [ABSTRACT FROM AUTHOR]

ABSTRACT In this paper, we present a model of an economy with household debt, and discuss the conditions under which financial fragility arises. Financial instability is driven by distributive effects. In addition to the income transfers associated with interest payments, the accumulation of debt feeds back with the distribution of income between labour and capital. The model also gives a central role to banks and credit rationing. Contrary to the existing literature, credit supply does not depend on the characteristics of borrowers, but on those of banks. There is a feedback channel between the health of the financial system and the quantity of credit in the economy. We show that there is a diversity of channels through which financial fragility may arise. We identify three channels: a debt-deflation effect à la Fisher, a credit-financed consumption boom and an exhilarating debt effect. [ABSTRACT FROM AUTHOR]