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A penalty function approach to occasionally binding credit constraints

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. Our simulations 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 National Bank of Poland, Economic Institute in its series National Bank of Poland Working Papers with number 159.

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Length: 48
Date of creation: 2013
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Handle: RePEc:nbp:nbpmis:159
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