Overborrowing and Systemic Externalities in the Business Cycle
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- 1 December 2011
- journal article
- Published by American Economic Association in American Economic Review
- Vol. 101 (7) , 3400-3426
- https://doi.org/10.1257/aer.101.7.3400
Abstract
Credit constraints linking debt to market-determined prices embody a systemic credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. This externality arises because private agents fail to internalize the financial amplification effects of carrying a large amount of debt when credit constraints bind. We conduct a quantitative analysis of this externality in a two-sector dynamic stochastic general equilibrium (DSGE) model of a small open economy calibrated to emerging markets. Raising the cost of borrowing during tranquil times restores constrained efficiency and significantly reduces the incidence and severity of financial crises. JEL: E13, E32, E44, F41, G01Keywords
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