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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. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis," Working Paper 9602, Federal Reserve Bank of Cleveland.
    2. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, American Economic Association, vol. 79(1), pages 14-31, March.
    3. Loretta J. Mester, 1993. "Why are credit card rates sticky?," Working Papers 93-16, Federal Reserve Bank of Philadelphia.
    4. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2001. "Default and Punishment in General Equilibrium," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1304R5, Cowles Foundation for Research in Economics, Yale University, revised Mar 2004.
    5. Ortalo-Magné, François & Rady, Sven, 2005. "Housing Market Dynamics: On the Contribution of Income Shocks and Credit Constraint," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 50, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
    6. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
    7. Gertler, Mark, 1990. "Financial Capacity And Output Fluctuations In An Economy With Multiperiod Financial Relationships," Working Papers, C.V. Starr Center for Applied Economics, New York University 90-44, C.V. Starr Center for Applied Economics, New York University.
    8. Stein, Jeremy C, 1995. "Prices and Trading Volume in the Housing Market: A Model with Down-Payment Effects," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 110(2), pages 379-406, May.
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    10. Pradeep Dubey & John Geanakoplos & Martin Shubik, 1988. "Default and Efficiency in a General Equilibrium Model with Incomplete Markets," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 879R, Cowles Foundation for Research in Economics, Yale University, revised Feb 1989.
    11. Brueckner, Jan K, 2000. "Mortgage Default with Asymmetric Information," The Journal of Real Estate Finance and Economics, Springer, Springer, vol. 20(3), pages 251-74, May.
    12. Philippe BACCHETTA & CRamon CAMINAL, 1996. "Do Capital Market Imperfections Exacerbate Output Fluctuations ?," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP), Université de Lausanne, Faculté des HEC, DEEP 9612, Université de Lausanne, Faculté des HEC, DEEP.
    13. Christopher L. House, 2002. "Adverse Selection and the Accelerator," Macroeconomics, EconWPA 0211015, EconWPA.
    14. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, Elsevier, vol. 16(2), pages 167-207, December.
    15. Allen, Franklin, 1981. "The Prevention of Default," Journal of Finance, American Finance Association, American Finance Association, vol. 36(2), pages 271-76, May.
    16. 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, Blackwell Publishing, vol. 22(2), pages 221-33, May.
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