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The Good, The Bad, and The Ugly: An Inquiry into the Causes and Nature of Credit Cycles

Author

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  • Kiminori Matsuyama

    (Department of Economics, Northwestern University)

Abstract

This paper builds models of nonlinear dynamics in the aggregate investment and borrower net worth and uses them to study the causes and nature of endogenous credit cycles. The basic model has two types of projects: the Good and the Bad. The Bad is highly productive, but, unlike the Good, it generates less aggregate demand spillovers and contributes little to improve borrower net worth. Furthermore, it is relatively difficult to finance externally due to the agency problem. With a low net worth, the agents cannot finance the Bad, and much of the credit goes to finance the Good, even when the Bad projects are more profitable than the Good projects. This over-investment to the Good creates a boom and generates high aggregate demand spillovers. This leads to an improvement in borrower net worth, which makes it possible for the agents to finance the Bad. This shift in the composition of the credit from the Good to the Bad at the peak of the boom causes a deterioration of net worth. The whole process repeats itself. Endogenous fluctuations occur, as the Good breeds the Bad, and the Bad destroys the Good. The model is then extended to add a third type of the projects, the Ugly, which are unproductive but easy to finance. With a low net worth, the Good competes with the Ugly, creating the credit multiplier effect; with a high net worth, the Good competes with the Bad, creating the credit reversal effect. By combining these two effects, this model generates intermittency phenomena, i.e., relatively long periods of small and persistent movements punctuated intermittently by seemingly random-looking behaviors. Along these cycles, the economy exhibits asymmetric fluctuations; it experiences a long and slow process of recovery from a recession, followed by a rapid expansion, and possibly after a period of high volatility, plunges into a recession.

Suggested Citation

  • Kiminori Matsuyama, 2004. "The Good, The Bad, and The Ugly: An Inquiry into the Causes and Nature of Credit Cycles," CIRJE F-Series CIRJE-F-294, CIRJE, Faculty of Economics, University of Tokyo.
  • Handle: RePEc:tky:fseres:2004cf294
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    References listed on IDEAS

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    1. Philippe Aghion & Abhijit Banerjee & Thomas Piketty, 1999. "Dualism and Macroeconomic Volatility," The Quarterly Journal of Economics, Oxford University Press, vol. 114(4), pages 1359-1397.
    2. Bengt Holmstrom & Jean Tirole, 1997. "Financial Intermediation, Loanable Funds, and The Real Sector," The Quarterly Journal of Economics, Oxford University Press, vol. 112(3), pages 663-691.
    3. Kiminori Matsuyama, 2000. "Endogenous Inequality," Review of Economic Studies, Oxford University Press, vol. 67(4), pages 743-759.
    4. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
    5. Kiminori Matsuyama, 2001. "On the Rise and Fall of Class Societies," Discussion Papers 1326, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    6. Boldrin, Michele & Woodford, Michael, 1990. "Equilibrium models displaying endogenous fluctuations and chaos : A survey," Journal of Monetary Economics, Elsevier, vol. 25(2), pages 189-222, March.
    7. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
    8. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 841-879.
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    Citations

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    Cited by:

    1. Kiminori Matsuyama, 2007. "Credit Traps and Credit Cycles," American Economic Review, American Economic Association, vol. 97(1), pages 503-516, March.
    2. Matteo Iacoviello & Raoul Minetti, 2006. "Liquidity Cycles," 2006 Meeting Papers 676, Society for Economic Dynamics.
    3. Nan-Kuang Chen & Hung-Jen Wang, 2007. "The Procyclical Leverage Effect Of Collateral Value On Bank Loans-Evidence From The Transaction Data Of Taiwan," Economic Inquiry, Western Economic Association International, vol. 45(2), pages 395-406, April.
    4. Felipe Iachan, 2012. "Liquidity Scarcity, Project Selection, and Volatility," 2012 Meeting Papers 480, Society for Economic Dynamics.
    5. repec:kap:annfin:v:13:y:2017:i:2:d:10.1007_s10436-017-0293-0 is not listed on IDEAS
    6. repec:eee:jbfina:v:87:y:2018:i:c:p:318-332 is not listed on IDEAS
    7. Takuma Kunieda & Akihisa Shibata, 2014. "Credit Market Imperfections and Macroeconomic Instability," Pacific Economic Review, Wiley Blackwell, vol. 19(5), pages 592-611, December.
    8. Iryna Sushko & Laura Gardini & Kiminori Matsuyama, 2014. "Chaos in a Model of Credit Cycles with Good and Bad Projects," Working Papers 1405, University of Urbino Carlo Bo, Department of Economics, Society & Politics - Scientific Committee - L. Stefanini & G. Travaglini, revised 2014.
    9. repec:ucp:macann:doi:10.1086/690244 is not listed on IDEAS
    10. Kikuchi, Tomoo & Vachadze, George, 2015. "Financial liberalization: Poverty trap or chaos," Journal of Mathematical Economics, Elsevier, vol. 59(C), pages 1-9.
    11. Paul Beaudry & Dana Galizia & Franck Portier, 2017. "Is the Macroeconomy Locally Unstable and Why Should We Care?," NBER Macroeconomics Annual, University of Chicago Press, vol. 31(1), pages 479-530.
    12. Agliari, Anna & Rillosi, Francesco & Vachadze, George, 2015. "Credit market imperfection, financial market globalization, and catastrophic transition," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 108(C), pages 41-62.
    13. Matsuyama, Kiminori & Sushko, Iryna & Gardini, Laura, 2016. "Revisiting the model of credit cycles with Good and Bad projects," Journal of Economic Theory, Elsevier, vol. 163(C), pages 525-556.

    More about this item

    JEL classification:

    • 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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