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American Economic Review: Vol. 101 No. 7 (December 2011)

AER Volume. 101, Issue 7 | Previous ArticleNext Article

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Overborrowing and Systemic Externalities in the Business Cycle

Article Citation

Bianchi, Javier. 2011. "Overborrowing and Systemic Externalities in the Business Cycle." American Economic Review, 101(7): 3400-3426.

DOI: 10.1257/aer.101.7.3400

Abstract

Credit constraints linking debt to market-determined prices embody a systemic credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. This externality arises because private agents fail to internalize the financial amplification effects of carrying a large amount of debt when credit constraints bind. We conduct a quantitative analysis of this externality in a two-sector dynamic stochastic general equilibrium (DSGE) model of a small open economy calibrated to emerging markets. Raising the cost of borrowing during tranquil times restores constrained efficiency and significantly reduces the incidence and severity of financial crises. (JEL: E13, E32, E44, F41, G01)

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Authors

Bianchi, Javier (NYU and U WI)

JEL Classifications

E13: General Aggregative Models: Neoclassical
E32: Business Fluctuations; Cycles
E44: Financial Markets and the Macroeconomy
F41: Open Economy Macroeconomics
G01: Financial Crises