Working Paper: CEPR ID: DP1604
Authors: Javier Suarez; Oren Sussman
Abstract: The literature on financial imperfections and business cycles has focused on propagation mechanisms. In this paper we model a pure reversion mechanism, such that the economy may converge to a two-period equilibrium cycle. This mechanism confirms that financial imperfections may have a dramatic amplification effect. Unlike some related models, contracts are complete. Indexation is not assumed away. The welfare properties of a possible stabilizing policy are analysed. The model itself is a dynamic extension of the well-known Stiglitz-Weiss model of lending under moral hazard. Although stylized, the model still captures some important features of credit cycles.
Keywords: credit rationing; endogenous cycles
JEL Codes: O82; E32; E51
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial imperfections (G59) | excessive risk-taking by entrepreneurs (L26) |
| excessive risk-taking by entrepreneurs (L26) | high rate of business failure (M13) |
| high liquidity (E41) | mitigated moral hazard problem (G52) |
| low liquidity (G19) | exacerbated risk-taking (G41) |
| subsidies during economic busts (H81) | enhanced liquidity (G19) |
| enhanced liquidity (G19) | reduced likelihood of failure (L15) |
| subsidies during economic busts (H81) | reduced likelihood of failure (L15) |