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

Feng Dong and Zhiwei Xu ()
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Feng Dong: Shanghai Jiao Tong University

No 444, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: Burgeoning empirical evidence suggests that credit booms may not only increase misallocation, but also sow seeds for financial crises. However, there is relative under-supply of theory accounting for these facts. To bridge the gap, we develop a unified general equilibrium banking model with heterogeneous firms to analyze the misallocation consequences of credit expansion policy both within and across sectors. The main insight is the trade-off between credit quantity and quality. On the one hand, a moderate credit expansion has a non-monotonic impact on the aggregate output. It raises credit potentially available for production at the cost of more severe productivity distortion. On the other hand, a sufficiently large credit expansion may trigger an inter-bank market crisis, generating discontinuous effect. The resulting economic recession is exacerbated by the firm-level productivity misallocation. By extending the static model to a dynamic environment, we show that an expansionary credit policy can generate endogenous boom-bust business cycles despite the absence of adverse shocks.

Date: 2018
New Economics Papers: this item is included in nep-dge and nep-mac
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Journal Article: Cycles of credit expansion and misallocation: The Good, the Bad and the Ugly (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed018:444

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