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The Good, The Bad, and The Ugly: An Inquiry into the Causes and Nature of Credit Cycles

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  • Kiminori Matsuyama

    (Department of Economics, Northwestern University)

Abstract

This paper builds models of nonlinear dynamics in the aggregate investment and borrower net worth and uses them to study the causes and nature of endogenous credit cycles. The basic model has two types of projects: the Good and the Bad. The Bad is highly productive, but, unlike the Good, it generates less aggregate demand spillovers and contributes little to improve borrower net worth. Furthermore, it is relatively difficult to finance externally due to the agency problem. With a low net worth, the agents cannot finance the Bad, and much of the credit goes to finance the Good, even when the Bad projects are more profitable than the Good projects. This over-investment to the Good creates a boom and generates high aggregate demand spillovers. This leads to an improvement in borrower net worth, which makes it possible for the agents to finance the Bad. This shift in the composition of the credit from the Good to the Bad at the peak of the boom causes a deterioration of net worth. The whole process repeats itself. Endogenous fluctuations occur, as the Good breeds the Bad, and the Bad destroys the Good. The model is then extended to add a third type of the projects, the Ugly, which are unproductive but easy to finance. With a low net worth, the Good competes with the Ugly, creating the credit multiplier effect; with a high net worth, the Good competes with the Bad, creating the credit reversal effect. By combining these two effects, this model generates intermittency phenomena, i.e., relatively long periods of small and persistent movements punctuated intermittently by seemingly random-looking behaviors. Along these cycles, the economy exhibits asymmetric fluctuations; it experiences a long and slow process of recovery from a recession, followed by a rapid expansion, and possibly after a period of high volatility, plunges into a recession.

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File URL: http://www.cirje.e.u-tokyo.ac.jp/research/dp/2004/2004cf294.pdf
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Bibliographic Info

Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE F-Series with number CIRJE-F-294.

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Length: 54 pages
Date of creation: Aug 2004
Date of revision:
Handle: RePEc:tky:fseres:2004cf294

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  1. Matsuyama, Kiminori, 2000. "Endogenous Inequality," Review of Economic Studies, Wiley Blackwell, vol. 67(4), pages 743-59, October.
  2. Boldrin, Michele & Woodford, Michael, 1990. "Equilibrium models displaying endogenous fluctuations and chaos : A survey," Journal of Monetary Economics, Elsevier, vol. 25(2), pages 189-222, March.
  3. Bengt Holmstrom & Jean Tirole, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," Working papers 95-1, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Hart, Oliver & Moore, John, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 841-79, November.
  5. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  6. 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.
  7. Kiminori Matsuyama, 2002. "On the Rise and Fall of Class Societies," CIRJE F-Series CIRJE-F-173, CIRJE, Faculty of Economics, University of Tokyo.
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Cited by:
  1. Kiminori Matsuyama, 2007. "Credit Traps and Credit Cycles," American Economic Review, American Economic Association, vol. 97(1), pages 503-516, March.

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