Cycles of Credit Expansion and Misallocation: The Good, the Bad and the Ugly

62 Pages Posted: 28 Oct 2018 Last revised: 13 Jan 2020

See all articles by Feng Dong

Feng Dong

Tsinghua University - School of Economics and Management

Zhiwei Xu

Fudan University - School of Economics

Date Written: October 4, 2018

Abstract

We offer a tractable dynamic theory where excessive credit creation by the frictional banking sector may lead to over-investment and then endogenous boom-bust cycles. We formalize the idea in a general equilibrium framework with banks and financially constrained heterogeneous firms. In the static model, a moderate credit expansion has a nonmonotonic positive impact on aggregate output, but an excessive credit expansion can trigger an interbank market crisis and result in a discontinuous sharp fall in aggregate output. By extending to a dynamic setting, we show that this mechanism can generate endogenous boom-bust business cycles despite the absence of adverse shocks.

Keywords: Credit Expansion, Volume-Composition Tradeoff, Financial Risk Capacity, Financial Crisis, Credit Cycles

JEL Classification: E32, E51

Suggested Citation

Dong, Feng and Xu, Zhiwei, Cycles of Credit Expansion and Misallocation: The Good, the Bad and the Ugly (October 4, 2018). Available at SSRN: https://ssrn.com/abstract=3260610 or http://dx.doi.org/10.2139/ssrn.3260610

Feng Dong

Tsinghua University - School of Economics and Management ( email )

School of Economics and Management
Tsinghua University
Beijing, Beijing 100084
China

HOME PAGE: http://fengdongecon.weebly.com

Zhiwei Xu (Contact Author)

Fudan University - School of Economics ( email )

600 GuoQuan Road
Shanghai, 200433
China

HOME PAGE: http://https://xuzhiwei09.wixsite.com/econ

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