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Collateral, credit history, and the financial decelerator

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  • Ronel Elul
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    Abstract

    The author develops a simple model in which financial imperfections can serve to stabilize aggregate fluctuations and not merely aggravate them as in much of the previous literature; the author terms this a financial decelerator. In the model agents borrow to purchase housing and secure their loans with this long-lived asset. There are two financial imperfections in this model. First, agents are unable to commit to repay their loans — that is, they can strategically default. This limits the amount that lenders are willing to offer. In addition, however, lenders are also imperfectly informed as to a borrower’s propensity to default; that is, there is adverse selection. The latter imperfection implies that default may actually occur in equilibrium, unlike in much of the previous literature. For relatively high house prices the commitment problem ensures that the equilibrium is typically characterized by a standard financial accelerator; that is, the borrowing constraints which prevent default become tighter as falling prices reduce the wealth with which agents can collateralize future loans, thereby exacerbating aggregate fluctuations. However, Elul shows that when prices are very low, agents will default, which serves as a stabilizing force; he terms this a financial decelerator. ; Also issued as Payment Cards Center Discussion Paper No. 05-14

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    Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 05-23.

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    Date of creation: 2005
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    Handle: RePEc:fip:fedpwp:05-23

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    Keywords: Credit ; Default (Finance);

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    1. Bacchetta, Philippe & Caminal, Ramón, 1996. "Do Capital Market Imperfections Exacerbate Output Fluctuations?," CEPR Discussion Papers 1422, C.E.P.R. Discussion Papers.
    2. Clauretie, Terrence M & Herzog, Thomas N, 1990. "The Effect of State Foreclosure Laws on Loan Losses: Evidence from the Mortgage Insurance Industry," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 22(2), pages 221-33, May.
    3. Gertler, Mark, 1992. "Financial Capacity and Output Fluctuations in an Economy with Multi-period Financial Relationships," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 455-72, July.
    4. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2001. "Default and Punishment in General Equilibrium," Cowles Foundation Discussion Papers 1304, Cowles Foundation for Research in Economics, Yale University.
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    6. Ortalo-Magné, François & Rady, Sven, 2001. "Housing Market Dynamics: On the Contribution of Income Shocks and Credit Constraints," CEPR Discussion Papers 3015, C.E.P.R. Discussion Papers.
    7. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, vol. 87(5), pages 893-910, December.
    8. Diamond, Douglas W, 1989. "Reputation Acquisition in Debt Markets," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 828-62, August.
    9. Jeremy C. Stein, 1993. "Prices and Trading Volume in the Housing Market: A Model with Downpayment Effects," NBER Working Papers 4373, National Bureau of Economic Research, Inc.
    10. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 865-88, October.
    11. Christopher L. House, 2002. "Adverse Selection and the Accelerator," Macroeconomics 0211015, EconWPA.
    12. Brueckner, Jan K, 2000. "Mortgage Default with Asymmetric Information," The Journal of Real Estate Finance and Economics, Springer, vol. 20(3), pages 251-74, May.
    13. Allen, Franklin, 1981. "The Prevention of Default," Journal of Finance, American Finance Association, vol. 36(2), pages 271-76, May.
    14. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
    15. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
    16. Mester, Loretta J, 1994. "Why Are Credit Card Rates Sticky?," Economic Theory, Springer, vol. 4(4), pages 505-30, May.
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