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American Economic Journal: Macroeconomics: Vol. 6 No. 1 (January 2014)

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Credit Constraints and Self-Fulfilling Business Cycles

Article Citation

Liu, Zheng, and Pengfei Wang. 2014. "Credit Constraints and Self-Fulfilling Business Cycles." American Economic Journal: Macroeconomics, 6(1): 32-69.

DOI: 10.1257/mac.6.1.32

Abstract

We argue that credit constraints not only amplify fundamental shocks, they can also lead to self-fulfilling business cycles. We study a model with heterogeneous firms, in which imperfect contract enforcement implies that productive firms face binding credit constraints, with the borrowing capacity limited by expected equity value. A drop in equity value tightens credit constraints and reallocates resources from productive to unproductive firms. Such reallocation reduces aggregate productivity, further depresses equity value, generating a financial multiplier. Aggregate dynamics are isomorphic to those in a representative-agent economy with increasing returns. For sufficiently tight credit constraints, the model generates self-fulfilling business cycles.

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Authors

Liu, Zheng (Federal Reserve Bank of San Francisco)
Wang, Pengfei (Hong Kong U Science and Technology)

JEL Classifications

E13: General Aggregative Models: Neoclassical
E32: Business Fluctuations; Cycles
E44: Financial Markets and the Macroeconomy

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