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Cycles of credit expansion and misallocation: The Good, the Bad and the Ugly

Feng Dong and Zhiwei Xu ()

Journal of Economic Theory, 2020, vol. 186, issue C

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 (search for similar items in EconPapers)
JEL-codes: E32 E51 (search for similar items in EconPapers)
Date: 2020
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Working Paper: Cycles of Credit Expansion and Misallocation: The Good, The Bad and The Ugly (2018) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:186:y:2020:i:c:s002205312030003x

DOI: 10.1016/j.jet.2020.104994

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