Macroeconomic Fluctuations

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Macroeconomic Fluctuations

Macroeconomic Fluctuations


In an environment with limited contract enforcement, economic agents have limited ability to borrow and loans need to be secured by collateral assets. Such credit constraints build a connection between asset prices and business investment, which provides a mechanism to amplify and propagate economic shocks and transform small shocks into large and persistent business cycle fluctuations (Lucas and Sergeant 2001 364-425).  


Do credit constraints amplify macroeconomic fluctuations? Existing studies find that the impact of credit constraints is muted (Artis 2006 36-48)). This finding is disappointing and indeed puzzling in light of the recent turmoil in the housing market and the concurrent deep recession. A positive answer to the question would change our way of macroeconomic argumentsing and our understanding of macroeconomic policy, as emphasized by (Ravn 2007 27-48).

Previous literature finds muted impacts of credit constraints because it focuses on total factor productivity (TFP) shocks (Evans 2003 524-637). A TFP shock does not have a large impact on asset prices because it moves future dividends and the risk-free interest rate in the same direction. Thus, the amplification mechanism cannot be activated by TFP shocks. TFP shocks contribute to the dynamics of aggregate output and investment through the usual channels that are familiar to a student of the RBC literature, but credit constraints do not amplify this type of shock. In general, credit constraints do not amplify nonfinancial shocks (such as the TFP shock) or financial shocks that shift the supply of an asset. In contrast, a shock that shifts the demand for a collateral asset generates a two-way feedback between the asset price and business investment through the channel of credit constraints. In our arguments, we find that housing demand shocks alone account for over 90% of the observed fluctuations in the housing price. Previous studies fail to obtain positive comovements between housing prices and business investment because they assume a subset of households, instead of entrepreneurs (productive agents), are credit-constrained (Muellbauer and Mayhew 2007 347-538). The distinction is subtle but important. Allowing entrepreneurs to be credit-constrained is an essential feature in our arguments for generating persistent comovements between the housing price and business investment. As the housing demand shock raises the land price, it also raises the entrepreneur's net worth and borrowing capacity, which provides an incentive for and enhances the ability of the entrepreneur to increase business investment. Through the dynamic interactions between the land price and investment made possible by credit constraints, a shock to housing demand is amplified and propagated to generate important macroeconomic fluctuations. Our estimation indicates that the housing demand shock alone accounts for 36 - 46% of the fluctuations in investment and 22 - 38% of the fluctuations in output. 


The original idea that borrowing constraints play a critical role in amplifying business cycles can be traced back at least to (Holden and Peel 2008 23-65). Our work is related to a recent strand of literature that builds on the work by (Pelloni 2007 474-76) and focuses on the costly state verification problem caused by asymmetric information between creditors and debtors (Grandmont 2001 293-9). Similar to the financial multiplier in (Pelloni 2007 474-76), the financial accelerator in (Grandmont 2001 293-9) can potentially amplify ...
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