Re-examining the role of financial constraints in business cycles: is something wrong with the credit multiplier?
AbstractA large theoretical literature suggests that financial frictions provide a mechanism which amplifies and propagates macroeconomic shocks. However, quantitative papers that embed this mechanism, referred to as the credit multiplier, into standard DSGE models conclude that although credit constraints delay the velocity at which productivity shocks propagate into the economy, they have no significant amplification effects, with the exception of special cases. Motivated by these results, in this paper we re-examine the quantitative role of financial frictions in business cycles to address the following question: is there something wrong with the credit multiplier? Our answer is no. In coming to this answer, we work with a model with reproducible capital and collateral constraints within two setups, a general and a partial equilibrium. Our results from the first model in terms of propagation and amplification do not differ from previous papers. However, our main finding is that it is not the credit multiplier what fails in this type of models, but rather their ability to produce sufficient variability in prices. In particular, in a model with reproducible capital, general equilibrium dynamics counteract the logic of price fluctuations described by theoretical models, thus preventing the credit multiplier from being triggered. The partial equilibrium setup allows us to confirm our previous claim: absent the general equilibrium effects, the credit multiplier is indeed an effective amplifying mechanism of shocks into the economy.
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Bibliographic InfoPaper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 377.
Date of creation: 2010
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