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A penalty function approach to occasionally binding credit constraints

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Abstract

Occasionally binding credit constraints (OBC) have recently been explored as a promising way of modeling financial frictions. However, given their highly non-linear nature, most of the literature has concentrated on small models that can be solved using global methods. In this paper, we investigate the workings of OBC introduced via a smooth penalty function. This allows us to move towards richer models that can be used for policy analysis. Our simulations show that in a deterministic setting the OBC approach delivers welcome features, like asymmetry and non-linearity in reaction to shocks. However, feasible local approximations, necessary to generate stochastic simulations, suffer from fatal shortcomings that make their practical application questionable.

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Bibliographic Info

Paper provided by National Bank of Poland, Economic Institute in its series National Bank of Poland Working Papers with number 159.

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Length: 48
Date of creation: 2013
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Handle: RePEc:nbp:nbpmis:159

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Keywords: financial frictions; DSGE models; occasionally binding constraints; penalty function;

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Cited by:
  1. Gerlach, Petra & Merola, Rossana, 2013. "Consumption and Credit Constraints: A Model and Evidence for Ireland," Papers WP471, Economic and Social Research Institute (ESRI).

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