On Optimal Credit Expansion

We derive a model of lending under imperfect information for investments with embedded real and financial flexibility. Risk-shifting is shown to be not inherent in loan agreements. Under certain assumptions, there exists an optimal credit expansion policy that fulfils the dual objective of stimulating investment and preventing risk shifting behaviour. Its existence helps in explaining why less volatile countries have a higher growth rate. More importantly, it suggests that a policy response of raising interest is not only impotent but it actually exacerbates speculative investments that cause credit-induced asset-price bubbles. Instead, a policy of de creasing interest rates with simultaneous tightening of lending requirements is a more effective tool for dealing with the damaging consequences of speculative investments.