Working Paper: NBER ID: w2015
Authors: Ben Bernanke; Mark Gertler
Abstract: Bad economic times are typically associated with a high incidence of financial distress, e.g., insolvency and bankruptcy. This paper studies the role of changes in borrower solvency in the initiation and propagation of the business cycle. We first develop a model of the process of financing real investment projects under asymmetric information, extending work by Robert Townsend. A major conclusion here is that when the entrepreneurs who borrow to finance projects are more solvent (have more "collateral"), the deadweight agency costs of investment finance are lower. This model of investment finance is then embedded in a dynamic macroeconomic setting. We show that, first, since reductions in collateral in bad times increase the agency costs of borrowing, which in turn depress the demand for investment, the presence of these financial factors will tend to amplify swings in real output. Second, we find that autonomous factors which affect the collateral of borrowers (as in a "debt-deflation") can actually initiate cycles in output.
Keywords: agency costs; collateral; business fluctuations; financial distress
JEL Codes: E32; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| reductions in collateral (G33) | increase in agency costs (G34) |
| increase in agency costs (G34) | depress investment demand (E22) |
| reductions in collateral (G33) | depress investment demand (E22) |
| autonomous factors affecting borrower collateral (G51) | reductions in collateral (G33) |
| reductions in collateral (G33) | decreased investment (E22) |
| decreased investment (E22) | negative impacts on aggregate demand and supply (E00) |