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The good, the bad, and the ugly: An inquiry into the causes and nature of credit cycles

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  • Matsuyama, Kiminori

    () (Department of Economics, Northwestern University)

Abstract

This paper builds models of nonlinear dynamics in the aggregate investment and borrower net worth to study the causes and nature of endogenous credit cycles. The basic model has two types of projects: the Good and the Bad. The Good projects rely on the inputs supplied by others who could undertake investment in the future, thereby improving their net worth. The Bad projects are independently profitable so that they do not improve the net worth of other borrowers. Furthermore, they are subject to the borrowing constraint due to some agency problems. With a low net worth, the agents cannot finance the Bad, and much of the credit goes to finance the Good, even when the Bad projects are more profitable than the Good projects. This over-investment to the Good creates a boom, leading to an improvement in borrower net worth. This makes it possible for the agents to finance the Bad. This shift in the composition of the credit from the Good to the Bad at the peak of the boom causes a deterioration of borrower net worth. The whole process repeats itself. Endogenous fluctuations occur, as the Good breed the Bad and the Bad destroy the Good. The model is then extended to add a third type of projects, the Ugly, which are unproductive but subject to no borrowing constraint. With a low net worth, the Good compete with the Ugly, which act as a drag on the Good, creating the credit multiplier effect. With a high net worth, the Good compete with the Bad, which destroy the Good, creating the credit reversal effect. By combining these two effects, this hybrid model generates intermittency phenomena, i.e., relatively long periods of small and persistent movements punctuated intermittently by seemingly random-looking behaviors. Along these cycles, the economy exhibits asymmetric fluctuations; it experiences a slow process of recovery from a recession, followed by a rapid expansion, and possibly after a period of high volatility, plunges into a recession.

Suggested Citation

  • Matsuyama, Kiminori, 2013. "The good, the bad, and the ugly: An inquiry into the causes and nature of credit cycles," Theoretical Economics, Econometric Society, vol. 8(3), September.
  • Handle: RePEc:the:publsh:1131
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    References listed on IDEAS

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    1. Philippe Aghion & Abhijit Banerjee & Thomas Piketty, 1999. "Dualism and Macroeconomic Volatility," The Quarterly Journal of Economics, Oxford University Press, vol. 114(4), pages 1359-1397.
    2. Bengt Holmstrom & Jean Tirole, 1997. "Financial Intermediation, Loanable Funds, and The Real Sector," The Quarterly Journal of Economics, Oxford University Press, vol. 112(3), pages 663-691.
    3. Kiminori Matsuyama, 2000. "Endogenous Inequality," Review of Economic Studies, Oxford University Press, vol. 67(4), pages 743-759.
    4. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
    5. Kiminori Matsuyama, 2001. "On the Rise and Fall of Class Societies," Discussion Papers 1326, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    6. Boldrin, Michele & Woodford, Michael, 1990. "Equilibrium models displaying endogenous fluctuations and chaos : A survey," Journal of Monetary Economics, Elsevier, vol. 25(2), pages 189-222, March.
    7. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
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    Citations

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    Cited by:

    1. Matteo Iacoviello & Raoul Minetti, 2006. "Liquidity Cycles," 2006 Meeting Papers 676, Society for Economic Dynamics.
    2. Nan-Kuang Chen & Hung-Jen Wang, 2007. "The Procyclical Leverage Effect Of Collateral Value On Bank Loans-Evidence From The Transaction Data Of Taiwan," Economic Inquiry, Western Economic Association International, vol. 45(2), pages 395-406, April.
    3. Felipe Iachan, 2012. "Liquidity Scarcity, Project Selection, and Volatility," 2012 Meeting Papers 480, Society for Economic Dynamics.
    4. Takuma Kunieda & Akihisa Shibata, 2014. "Credit Market Imperfections and Macroeconomic Instability," Pacific Economic Review, Wiley Blackwell, vol. 19(5), pages 592-611, December.
    5. Kikuchi, Tomoo & Vachadze, George, 2015. "Financial liberalization: Poverty trap or chaos," Journal of Mathematical Economics, Elsevier, vol. 59(C), pages 1-9.
    6. Paul Beaudry & Dana Galizia & Franck Portier, 2017. "Is the Macroeconomy Locally Unstable and Why Should We Care?," NBER Macroeconomics Annual, University of Chicago Press, vol. 31(1), pages 479-530.
    7. Matsuyama, Kiminori & Sushko, Iryna & Gardini, Laura, 2016. "Revisiting the model of credit cycles with Good and Bad projects," Journal of Economic Theory, Elsevier, vol. 163(C), pages 525-556.
    8. Kiminori Matsuyama, 2007. "Credit Traps and Credit Cycles," American Economic Review, American Economic Association, vol. 97(1), pages 503-516, March.
    9. repec:kap:annfin:v:13:y:2017:i:2:d:10.1007_s10436-017-0293-0 is not listed on IDEAS
    10. repec:eee:jbfina:v:87:y:2018:i:c:p:318-332 is not listed on IDEAS
    11. Iryna Sushko & Laura Gardini & Kiminori Matsuyama, 2014. "Chaos in a Model of Credit Cycles with Good and Bad Projects," Working Papers 1405, University of Urbino Carlo Bo, Department of Economics, Society & Politics - Scientific Committee - L. Stefanini & G. Travaglini, revised 2014.
    12. repec:eee:moneco:v:95:y:2018:i:c:p:97-108 is not listed on IDEAS
    13. Agliari, Anna & Rillosi, Francesco & Vachadze, George, 2015. "Credit market imperfection, financial market globalization, and catastrophic transition," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 108(C), pages 41-62.

    More about this item

    Keywords

    Net worth; borrowing constraints; heterogeneous projects; demand spillovers; credit multiplier; credit reversal; financial instability; endogenous credit cycles; nonlinear dynamics; intermittency; asymmetric fluctuations;

    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

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