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Credit Constraints and Self-Fulfilling Business Cycles

  • Zheng Liu
  • Pengfei Wang

We argue that credit constraints not only amplify fundamental shocks, they can also lead to self-fulfilling business cycles. We study a model with heterogeneous firms, in which imperfect contract enforcement implies that productive firms face binding credit constraints, with the borrowing capacity limited by expected equity value. A drop in equity value tightens credit constraints and reallocates resources from productive to unproductive firms. Such reallocation reduces aggregate productivity, further depresses equity value, generating a financial multiplier. Aggregate dynamics are isomorphic to those in a representative-agent economy with increasing returns. For sufficiently tight credit constraints, the model generates self-fulfilling business cycles.

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Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 6 (2014)
Issue (Month): 1 (January)
Pages: 32-69

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Handle: RePEc:aea:aejmac:v:6:y:2014:i:1:p:32-69
Note: DOI: 10.1257/mac.6.1.32
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