Working Paper: NBER ID: w27472
Authors: Maryam Farboodi; Pter Kondor
Abstract: We propose a rational model of endogenous cycles generated by the two-way interaction between credit market sentiments and real outcomes. Sentiments are high when most lenders optimally choose lax lending standards. This leads to low interest rates and high output growth, but also to the deterioration of future credit application quality. When the quality is sufficiently low, lenders endogenously switch to tight standards, i.e. sentiments become low. This implies high credit spreads and low output, but a gradual improvement in the quality of applications, which eventually triggers a shift back to lax lending standards and the cycle continues. The equilibrium cycle might feature a long boom, a lengthy recovery, or a double-dip recession. It is generically different from the optimal cycle as atomistic lenders ignore their effect on the composition of the pool of borrowers. Carefully chosen macro-prudential or countercyclical monetary policy often improves the decentralized equilibrium cycle.
Keywords: No keywords provided
JEL Codes: D82; E32; E44; G01; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high credit market sentiments (E44) | low interest rates (E43) |
| high credit market sentiments (E44) | high output growth (O40) |
| lax lending standards (G21) | low interest rates (E43) |
| lax lending standards (G21) | high output growth (O40) |
| deterioration of credit applications (G21) | tight lending standards (G21) |
| tight lending standards (G21) | high credit spreads (G19) |
| tight lending standards (G21) | low output (E23) |
| high credit market sentiments (E44) | deterioration of credit applications (G21) |
| high output growth (O40) | deterioration of credit applications (G21) |
| deterioration of credit applications (G21) | low output (E23) |