Overborrowing and Systemic Externalities in the Business Cycle

Preprint
Publisher Website
Google Scholar
  • 1 January 2010
    • preprint
      • Published in RePEc
Abstract
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 price effects of additional borrowing when the credit constraint binds. We quantify the effects of this inefficiency in a two-sector DSGE model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of 7 and causes the maximum drop in consumption to increase by 10 percentage points.

This publication has 0 references indexed in Scilit: