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A penalty function approach to occasionally binding credit constraints

  • Brzoza-Brzezina, Michał
  • Kolasa, Marcin
  • Makarski, Krzysztof

Occasionally binding credit constraints (OBC) have recently been explored as a promising way of modeling financial frictions. However, given their highly non-linear nature, most of the literature has concentrated on small models that can be solved using global methods. In this paper, we investigate the workings of OBC introduced via a smooth penalty function. This allows us to move towards richer models that can be used for policy analysis. We show that in a deterministic setting the OBC approach delivers welcome features, like asymmetry and non-linearity in reaction to shocks. However, feasible local approximations, necessary to generate stochastic simulations, suffer from fatal shortcomings that make their practical application questionable.

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Paper provided by CEPREMAP in its series Dynare Working Papers with number 27.

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Length: 36 pages
Date of creation: Jun 2013
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Handle: RePEc:cpm:dynare:027
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