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Inefficient Credit Booms

  • Guido Lorenzoni

This paper studies the welfare properties of competitive equilibria in an economy with financial frictions hit by aggregate shocks. In particular, it shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post. Even though from a first-best perspective the equilibrium always displays under-borrowing, from a second-best point of view excessive borrowing can arise. The inefficiency is due to the combination of limited commitment in financial contracts and the fact that asset prices are determined in a spot market. This generates a pecuniary externality that is not internalized in private contracts. The model provides a framework to evaluate preventive policies, which can be used during a credit boom to reduce the expected costs of a financial crisis. Copyright 2008, Wiley-Blackwell.

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Article provided by Oxford University Press in its journal The Review of Economic Studies.

Volume (Year): 75 (2008)
Issue (Month): 3 ()
Pages: 809-833

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Handle: RePEc:oup:restud:v:75:y:2008:i:3:p:809-833
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