Credit Constraints and Self-Fulfilling Business Cycles

Authors

Pengfei Wang

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2010-22 | September 1, 2011

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.

Article Citation

Wang, Pengfei, and Zheng Liu. 2010. “Credit Constraints and Self-Fulfilling Business Cycles,” Federal Reserve Bank of San Francisco Working Paper 2010-22. Available at https://doi.org/10.24148/wp2010-22

About the Author
Zheng Liu
Zheng Liu is a vice president and director of the Center for Pacific Basin Studies in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Zheng Liu