Cleansing by tight credit: rational cycles and endogenous lending standards

Maryam Farboodi and Péter Kondor

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: Endogenous cycles are generated by the two-way interaction between lenders' behavior in the credit market and production fundamentals. When lenders choose credit quantity over quality, the resulting lax lending standards lead to low interest rates and high output growth but the deterioration of future loan quality. When the quality is sufficiently low, lenders change their behavior and switch to tight standards, causing high credit spreads and low growth but a gradual improvement in the quality of loans. This eventually triggers a shift back to a boom with lax lending, and the cycle continues. Lenders fail to internalize that tight lending standards cleanse the economy of low quality borrowers and lead to healthier subsequent booms. Therefore, carefully chosen macro-prudential or counter-cyclical monetary policy often improves the decentralized equilibrium cycle.

Keywords: cleansing role of recession; lending standards; endogenous cycles; adverse selection; information choice (search for similar items in EconPapers)
JEL-codes: D82 E32 E44 G10 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2021-10-22
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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http://eprints.lse.ac.uk/118900/ Open access version. (application/pdf)

Related works:
Journal Article: Cleansing by tight credit: Rational cycles and endogenous lending standards (2023)
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