Financial Crises and Economic Growth
Robert A. Jarrow
Cornell University - Samuel Curtis Johnson Graduate School of Management
February 2, 2012
Johnson School Research Paper Series No. 37-2011
This paper constructs a simple yet robust model of financial crises and economic growth where financial markets affect real economic activity. Financial markets increase real output by facilitating investment through the borrowing/lending of capital. However, the borrowing of capital is risky due to randomness in the firm's production. Financial crises occur when output and liquid capital are insufficient to meet required loan payments and systemic defaults occur. In this model, a financial crisis caused by systemic defaults can shift the economy from an equilibrium with positive borrowing/lending to an equilibrium with no borrowing/lending. In this no-lending equilibrium, neither traditional fiscal or monetary policy tools are effective in increasing output. Fiscal and monetary policy can only increase the likelihood of the equilibrium evolving to a borrowing/lending equilibrium.
Number of Pages in PDF File: 35working papers series
Date posted: September 21, 2011 ; Last revised: February 7, 2012
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