Working Paper: NBER ID: w13639
Authors: Guido Lorenzoni
Abstract: This paper studies the welfare properties of competitive equilibria in an economy with financial frictions hit by aggregate shocks. In particular, it shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post. Even though, from a first-best perspective the equilibrium always displays under-borrowing, from a second-best point of view excessive borrowing can arise. The inefficiency is due to the combination of limited commitment in financial contracts and the fact that asset prices are determined in a spot market. This generates a pecuniary externality that is not internalized in private contracts. The model provides a framework to evaluate preventive policies which can be used during a credit boom to reduce the expected costs of a financial crisis.
Keywords: credit booms; financial frictions; macroprudential policy; welfare analysis; pecuniary externality
JEL Codes: E32; E44; E61; G10; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| excessive borrowing (F65) | increased volatility in asset prices (G19) |
| limited commitment in financial contracts (G19) | excessive borrowing (F65) |
| excessive borrowing (F65) | pecuniary externality (D62) |
| planner's decisions (R58) | equilibrium outcomes (D51) |
| aggregate investment ex ante (E22) | negative effects of asset sales in bad states (G32) |
| reduction in aggregate investment ex ante (E22) | increase in asset prices (G19) |
| financial frictions on borrowers and lenders (G21) | inefficiencies (D61) |
| financial frictions (G19) | overborrowing (H74) |