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Inefficient Credit Booms

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  • Guido Lorenzoni

Abstract

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.

Suggested Citation

  • Guido Lorenzoni, 2008. "Inefficient Credit Booms," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 75(3), pages 809-833.
    • Handle: RePEc:oup:restud:v:75:y:2008:i:3:p:809-833
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    File URL: http://hdl.handle.net/10.1111/j.1467-937X.2008.00494.x
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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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