The debt liquidation process is set in motion because of some random shock, for instance, a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.
As a result of the debt liquidation the money stock starts shrinking, and this in turn slows down the velocity of money.
A fall in money leads to a decline in the price level.
The value of people's assets falls while the value of their liabilities remains intact. This results in a fall in the net worth, which precipitates bankruptcies.
Profits start to decline, and losses emerge.
Production, trade, and employment are curtailed.
All this leads to growing pessimism and a loss of confidence.
This in turn leads to the hoarding of money and a further slowing in the velocity of money.
Nominal interest rates fall, however; but because of a fall in prices, real interest rates rise.
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