Rational Sentiments and Economic Cycles

Maryam Farboodi and Péter Kondor

No 27472, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We propose a rational model of endogenous cycles generated by the two-way interaction between credit market sentiments and real outcomes. Sentiments are high when most lenders optimally choose lax lending standards. This leads to low interest rates and high output growth, but also to the deterioration of future credit application quality. When the quality is sufficiently low, lenders endogenously switch to tight standards, i.e. sentiments become low. This implies high credit spreads and low output, but a gradual improvement in the quality of applications, which eventually triggers a shift back to lax lending standards and the cycle continues. The equilibrium cycle might feature a long boom, a lengthy recovery, or a double-dip recession. It is generically different from the optimal cycle as atomistic lenders ignore their effect on the composition of the pool of borrowers. Carefully chosen macro-prudential or countercyclical monetary policy often improves the decentralized equilibrium cycle.

JEL-codes: D82 E32 E44 G01 G10 (search for similar items in EconPapers)
Date: 2020-07
New Economics Papers: this item is included in nep-ban, nep-fdg and nep-mac
Note: CF EFG
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