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Is the High Interest Rate Combined with Intense Deleveraging Campaign Desirable? A Collateral Mechanism under Stringent Credit Constraints

Qiuyi Yang (), Youze Lang () and Changsheng Xu ()
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Qiuyi Yang: School of Economics, Huazhong University of Science and Technology, 1037 Luoyu Road, Wuhan 430074, China
Youze Lang: School of Economics, Shanghai University of Finance and Economics, 111 Wuchuan Road, Shanghai 200433, China
Changsheng Xu: School of Economics, Huazhong University of Science and Technology, 1037 Luoyu Road, Wuhan 430074, China

Sustainability, 2018, vol. 10, issue 12, 1-22

Abstract: Recently, China has witnessed a continuously increasing Debt-to-GDP ratio and a vigorously expanding shadow banking sector. Housing prices hovering at a high level seriously affect the lives of ordinary residents. Disappointingly, a variety of activities such as intense deleveraging campaigns and tight monetary controls produce little effect. Why do these seemingly rightful implementations hardly work? What should governments do to stop the incessant expansion of asset bubbles? What role ought financial supervisors to play in regulating credit markets and facilitating a sustainable and inclusive economic growth? This paper sets off from the pledgeability of asset bubbles and constructs a generalized overlapping generation (OLG) model incorporating financial frictions and collateral constraints, in order to explore the bubble evolution under the alterations of market interest rates and credit conditions. The results show a unique bubble equilibrium, in which the steady-state bubble size expands when interest rate increases. Numerical results further reveal that the bubble-inflation effect of a higher interest rate is reinforced by a more stringent collateral constraint. Our research contributes to an explanation of the inefficacy of present policies and provides the following policy implications: The combination of an interest rate elevation and a strong loan restriction is in fact undesirable for suppressing asset bubbles. Not merely does it strike productivity and capital formation, but it also fosters investors to hold more risky assets to solve liquidity shortage under constrained borrowing capacity.

Keywords: sustainable financial market; asset bubbles; overlapping generation (OLG) model; market interest rate; credit constraints; pledgeability; financial regulation and supervision (search for similar items in EconPapers)
JEL-codes: Q Q0 Q2 Q3 Q5 Q56 O13 (search for similar items in EconPapers)
Date: 2018
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