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Overborrowing and Systemic Externalities in the Business Cycle

  • Javier Bianchi

Credit constraints linking debt to market-determined prices embody a systemic credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. This externality arises because private agents fail to internalize the financial amplification effects of carrying a large amount of debt when credit constraints bind. We conduct a quantitative analysis of this externality in a two-sector dynamic stochastic general equilibrium (DSGE) model of a small open economy calibrated to emerging markets. Raising the cost of borrowing during tranquil times restores constrained efficiency and significantly reduces the incidence and severity of financial crises. (JEL: E13, E32, E44, F41, G01)

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 101 (2011)
Issue (Month): 7 (December)
Pages: 3400-3426

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Handle: RePEc:aea:aecrev:v:101:y:2011:i:7:p:3400-3426
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