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Inefficient Credit Booms

  • Guido Lorenzoni

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.

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File URL: http://www.nber.org/papers/w13639.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13639.

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Date of creation: Nov 2007
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Publication status: published as Guido Lorenzoni, 2008. "Inefficient Credit Booms," Review of Economic Studies, Blackwell Publishing, vol. 75(3), pages 809-833, 07.
Handle: RePEc:nbr:nberwo:13639
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