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The perils of credit booms

Feng Dong (), Jianjun Miao () and Pengfei Wang ()
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Feng Dong: Shanghai Jiao Tong University
Pengfei Wang: Hong Kong University of Science and Technology

Economic Theory, 2018, vol. 66, issue 4, 819-861

Abstract: Abstract We present a dynamic general equilibrium model of production economies with adverse selection in the financial market to study the interaction between funding liquidity and market liquidity and its impact on business cycles. Entrepreneurs can take on short-term collateralized debt and trade long-term assets to finance investment. Funding liquidity can erode market liquidity. High funding liquidity discourages firms from selling their good long-term assets since these good assets have to subsidize lemons when there is information asymmetry. This can cause a liquidity dry-up in the market for long-term assets and even a market breakdown, resulting in a financial crisis. Multiple equilibria can coexist. Credit booms combined with changes in beliefs can cause equilibrium regime shifts, leading to an economic crisis or expansion.

Keywords: Adverse selection; Liquidity; Collateral; Bubbles; Credit boom; Financial crises; Multiple equilibria (search for similar items in EconPapers)
JEL-codes: E2 E44 G01 G20 (search for similar items in EconPapers)
Date: 2018
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