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Cash flows and credit cycles

Nicolás Figueroa and Oksana Leukhina ()

Journal of Banking & Finance, 2018, vol. 87, issue C, 318-332

Abstract: Aggregate productivity falls in recessions and rises in expansions. Several empirical studies suggest that the systematic behavior of lending standards, with laxer (tighter) standards applied during expansions (recessions), is responsible for reverting trends in aggregate productivity. We build a dynamic model that rationalizes these findings. Adverse selection in credit markets emerges as a potential source of macroeconomic instability. The key idea modeled is that in order to effectively signal their type to financiers, productive entrepreneurs must suffer a cost. The effective cost of signaling rises with higher cash flow brought about by stronger economic fundamentals, because higher cash flow makes it easier for the unproductive type to mimic the productive type. Competition among the financiers then results in suboptimally lax lending standards. Low productivity entrepreneurs obtain financing, the producer composition effect inducing a recession. This, in turn, creates conditions – weak economic fundamentals and low cash flow – conducive to the emergence of tighter lending terms, the strong composition effect leading to an economic recovery.

Keywords: Macroeconomic instability; Financial instability; Lending standards; Adverse selection (search for similar items in EconPapers)
JEL-codes: E32 E44 G20 (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1016/j.jbankfin.2017.10.013

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Handle: RePEc:eee:jbfina:v:87:y:2018:i:c:p:318-332