Chain Reactions, Trade Credit and the Business Cycle

Firms in poor countries often tend to rely on alternative sources of financing different than banks. We show that borrowing constraints lead to financial arrangements between firms that can amplify the effect of liquidity or productivity shocks in the economy. In particular, we focus on the effects of trade credit. Widespread borrowing and lending between firms implies the establishment of relationships that can serve as a way to transmit economic shocks. In other words, trade credit creates a network of firms, all of them linked by the credit given to each other and all of them exposed to the temporary problems the others might have. We develop in this chapter a model based on the ideas of Kiyotaki and Moore (1997). Our model however, is a general equilibrium version of theirs that deals with the aggregate consequences that temporary productivity or liquidity shocks might have on the whole economy. Our results show that in a carefully calibrated model, the effects of these credit chains are quite important. In particular, in an economy like Mexico where 65% of firms claim their main source of financing to be other firms, the impact of productivity shocks is significant and three times bigger than in an economy with levels of trade credit use close to the US case