Overborrowing and Systemic Externalities in the Business Cycle

Javier Bianchi
Working Paper 2009-24
September 2009

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Credit constraints that link a private agent’s debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. The externality arises because agents fail to internalize the debt-deflation effects of additional borrowing when negative income shocks trigger the credit constraint. We quantify the effects of this inefficiency in a two-sector dynamic stochastic general equilibrium model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of seven and causes the maximum drop in consumption to increase by 10 percentage points.

JEL classification: D62, E32, E44, F32, F41

Key words: financial crises, amplification effects, business cycles, constrained efficiency

The author thanks Enrique Mendoza for his guidance and advice. He is also grateful to Anton Korinek and John Shea for encouragement and invaluable suggestions. For useful suggestions and comments, he thanks Juan Dubra, Pablo D'Erasmo, Bertrand Gruss, Alessandro Rebucci, and seminar participants at the University of Maryland, the Universidad de Montevideo, and the Federal Reserve Bank of Atlanta. This research was completed while the author was a visiting scholar at the Federal Reserve Bank of Atlanta, which he thanks for its hospitality. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.

Please address questions regarding content to Javier Bianchi, Department of Economics, University of Maryland, 3105 Tydings Hall, College Park, MD 20742, 301-405-3266, bianchi@econ.umd.edu.

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