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Overborrowing and systemic externalities in the business cycle

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Javier Bianchi

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Abstract

Credit constraints that link a private agent’s debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. The externality arises because agents fail to internalize the debt-deflation effects of additional borrowing when negative income shocks trigger the credit constraint. We quantify the effects of this inefficiency in a two-sector dynamic stochastic general equilibrium model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of seven and causes the maximum drop in consumption to increase by 10 percentage points.

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Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2009-24.

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Date of creation: 2009
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Handle: RePEc:fip:fedawp:2009-24

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