Credit Cycles Redux*

Abstract

Theoretical studies have shown that under unorthodox assumptions on preferences and production technologies, collateral constraints can act as a powerful amplification and propagation mechanism of exogenous shocks. We investigate whether or not this result holds under more standard assumptions. We find that collateral constraints typically generate small output amplification. Large amplification is obtained as a "knife-edge" type of result.

The Inverted Leading Indicator Property and Redistribution Effect of the Interest Rate

“…To illustrate this point in an ad-hoc fashion, we reestimate the model under the assumption that redistribution shocks follow an AR(1) process. 19 The outcome is that the estimated autocorrelation parameter of redistribution is quite large (see Table 10). In such model, therefore, redistribution shocks have a persistent effect on the interest rate (see Figure 13) and it follows that their contribution in the variance decomposition is now far from negligible (see Figure 14).…”

“…However, this literature shows that the KM constraint alone is not sufficient for generating the anticipated propagation mechanism (Kocherlakota, 2000, Cordoba and Ripoll, 2004, Pintus and Wen, 2013) and self-fulfilling business cycles, unless additional features or frictions such as fixed cost of production or transaction are added in conjunction with collateralized borrowing to generate self-fulfilling business cycles (see e.g. Benhabib and Wang, 2013, Liu and Wang, Figure 1: IRFs from VAR model with land price ordered first -one standard deviation shock (±2 standard-error bands) The intuition is straightforward: under a predetermined interest rate, simply relaxing the borrowing constraint via a higher value of the collateral does not by itself generate a higher demand for loans if the loan interest rate is expected to rise.…”

Collateral constraints and the amplification-persistence trade-off

“…Ripoll [3] remains valid here: when capital accumulation and fractional collateral are added to the analysis, collateral constraints still have small quantitative effects, especially on aggregate output. 4 However, this fact does not imply that collateral constraints are quantitatively insignificant.…”

“…In particular, the benchmark model, featuring concave utility and production functions and neo-classical input accumulation, does not predict an amplification-persistence trade-off to occur because of collateral constraints. Although the model is arguably standard in many dimensions (it is indeed similar to Cordoba and Ripoll's [3]), it remains to be seen if the same conclusion stands in alternative settings with different credit market frictions.…”

“…Among others, Kocherlakota [8] works out an open-4 economy model which exhibits a similar trade-off but relies on an exogenous interest rate, just as KM's. Cordoba and Ripoll [3] study a model that shares many similarities with the setting considered in this paper. However, these authors introduce reproducible land but not reproducible capital, so that their model is less comparable to KM's than the setting considered in this paper.…”