Working Papers

2010-22 | September 2011

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Credit Constraints and Self-Fulfilling Business Cycles

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We argue that credit constraints not just amplify fundamental shocks, they can also lead to self-fulfilling business cycles. To make this point, we study a model in which productive firms are credit constrained, with credit limits determined by equity value. A drop in equity value tightens credit constraints and reallocates resources from productive to unproductive firms. This reallocation reduces aggregate productivity and further depresses equity value and further tightens credit constraints, generating a financial multiplier that amplifies the effects of fundamental shocks. At the aggregate level, credit externality manifests as increasing returns and thus can lead to self-fulfilling business cycles.

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