Cycles of Credit Expansion and Misallocation: The Good, the Bad and the Ugly
62 Pages Posted: 28 Oct 2018 Last revised: 13 Jan 2020
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: Suggested Citation