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Overborrowing and Systemic Externalities in the Business Cycle

  • Javier Bianchi

Credit constraints that link a private agent's debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to ``overborrow." The externality arises because agents fail to internalize the price effects of additional borrowing when the credit constraint binds. We quantify the effects of this inefficiency in a two-sector DSGE model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of 7 and causes the maximum drop in consumption to increase by 10 percentage points.

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Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 96.

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Date of creation: 2010
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Handle: RePEc:red:sed010:96
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