Indeterminate credit cycles
AbstractWe present a model with heterogeneous firms, in which credit constraints may give rise to self-fulfilling, sunspot-driven business cycle fluctuations. We derive optimal incentive-compatible loan contracts, under which a firm’s borrowing capacity is constrained by expected equity value. Interactions between debt and equity value made possible by credit constraints generate a credit externality, which leads to procyclical total factor productivity (TFP) and, with sufficiently high cost of financial intermediation, to equilibrium indeterminacy. At the aggregate level, the credit externality is observationally equivalent to production externality. Aggregate dynamics in our model with credit constraints and constant returns technology at the firm level are isomorphic to those in an aggregate economy with increasing returns, such as that studied by Benhabib and Farmer (1994).
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Bibliographic InfoPaper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2010-22.
Date of creation: 2010
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-10-16 (All new papers)
- NEP-BAN-2010-10-16 (Banking)
- NEP-CTA-2010-10-16 (Contract Theory & Applications)
- NEP-DGE-2010-10-16 (Dynamic General Equilibrium)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Roger E.A. Farmer & Jang Ting Guo, 1992.
"Real Business Cycles and the Animal Spirits Hypothesis,"
UCLA Economics Working Papers
680, UCLA Department of Economics.
- Farmer Roger E. A. & Guo Jang-Ting, 1994. "Real Business Cycles and the Animal Spirits Hypothesis," Journal of Economic Theory, Elsevier, vol. 63(1), pages 42-72, June.
- Stephanie Schmitt-Grohe, 1995.
"Comparing four models of aggregate fluctuations due to self-fulfilling expectations,"
Finance and Economics Discussion Series
95-17, Board of Governors of the Federal Reserve System (U.S.).
- Schmitt-Grohe, Stephanie, 1997. "Comparing Four Models of Aggregate Fluctuations due to Self-Fulfilling Expectations," Journal of Economic Theory, Elsevier, vol. 72(1), pages 96-147, January.
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