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Indeterminate credit cycles

Zheng Liu () and Pengfei Wang ()

No 2010-22, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: We present a model with heterogeneous firms, in which credit constraints may give rise to self-fulfilling, sunspot-driven business cycle fluctuations. We derive optimal incentive-compatible loan contracts, under which a firm?s borrowing capacity is constrained by expected equity value. Interactions between debt and equity value made possible by credit constraints generate a credit externality, which leads to procyclical total factor productivity (TFP) and, with sufficiently high cost of financial intermediation, to equilibrium indeterminacy. At the aggregate level, the credit externality is observationally equivalent to production externality. Aggregate dynamics in our model with credit constraints and constant returns technology at the firm level are isomorphic to those in an aggregate economy with increasing returns, such as that studied by Benhabib and Farmer (1994).

Keywords: Credit (search for similar items in EconPapers)
Date: 2010
New Economics Papers: this item is included in nep-ban, nep-cta and nep-dge
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