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Cycles of credit expansion and misallocation: The Good, the Bad and the Ugly

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  • Dong, Feng
  • Xu, Zhiwei

Abstract

We offer a tractable dynamic theory where excessive credit creation by the frictional banking sector may lead to over-investment and then endogenous boom-bust cycles. We formalize the idea in a general equilibrium framework with banks and financially constrained heterogeneous firms. In the static model, a moderate credit expansion has a nonmonotonic positive impact on aggregate output, but an excessive credit expansion can trigger an interbank market crisis and result in a discontinuous sharp fall in aggregate output. By extending to a dynamic setting, we show that this mechanism can generate endogenous boom-bust business cycles despite the absence of adverse shocks.

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  • Dong, Feng & Xu, Zhiwei, 2020. "Cycles of credit expansion and misallocation: The Good, the Bad and the Ugly," Journal of Economic Theory, Elsevier, vol. 186(C).
  • Handle: RePEc:eee:jetheo:v:186:y:2020:i:c:s002205312030003x
    DOI: 10.1016/j.jet.2020.104994
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    Cited by:

    1. Feng Dong, . "Aggregate Implications of Financial Frictions for Unemployment," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
    2. Dong, Feng & Jia, Yandong & Wang, Siqing, 2022. "Speculative Bubbles and Talent Misallocation," Journal of Economic Dynamics and Control, Elsevier, vol. 141(C).

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    More about this item

    Keywords

    Credit expansion; Volume-composition tradeoff; Financial risk capacity; Financial crisis; Credit cycles;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers

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