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Re-examining the role of financial constraints in business cycles: is something wrong with the credit multiplier?

Author

Listed:
  • Jessica Roldan Pena

    (UCLA)

  • Virginia Olivella

    (UCLA)

Abstract

A large theoretical literature suggests that financial frictions provide a mechanism which amplifies and propagates macroeconomic shocks. However, quantitative papers that embed this mechanism, referred to as the credit multiplier, into standard DSGE models conclude that although credit constraints delay the velocity at which productivity shocks propagate into the economy, they have no significant amplification effects, with the exception of special cases. Motivated by these results, in this paper we re-examine the quantitative role of financial frictions in business cycles to address the following question: is there something wrong with the credit multiplier? Our answer is no. In coming to this answer, we work with a model with reproducible capital and collateral constraints within two setups, a general and a partial equilibrium. Our results from the first model in terms of propagation and amplification do not differ from previous papers. However, our main finding is that it is not the credit multiplier what fails in this type of models, but rather their ability to produce sufficient variability in prices. In particular, in a model with reproducible capital, general equilibrium dynamics counteract the logic of price fluctuations described by theoretical models, thus preventing the credit multiplier from being triggered. The partial equilibrium setup allows us to confirm our previous claim: absent the general equilibrium effects, the credit multiplier is indeed an effective amplifying mechanism of shocks into the economy.

Suggested Citation

  • Jessica Roldan Pena & Virginia Olivella, 2010. "Re-examining the role of financial constraints in business cycles: is something wrong with the credit multiplier?," 2010 Meeting Papers 377, Society for Economic Dynamics.
  • Handle: RePEc:red:sed010:377
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    References listed on IDEAS

    as
    1. Chen, Nan-Kuang, 2001. "Bank net worth, asset prices and economic activity," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 415-436, October.
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    More about this item

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • 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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