Collateral, Credit History, and the Financial Decelerator

Abstract:     
We develop a simple model in which financial imperfections can serve to stabilize aggregate fluctuations and not merely aggravate them as in much of the previous literature; we term this a financial decelerator.

In our model agents borrow to purchase housing and secure their loans with this long-lived asset. There are two financial imperfections in this model. First, agents are unable to commit to repay their loans - that is, they can strategically default. This limits the amount that lenders are willing to offer. In addition, however, lenders are also imperfectly informed as to a borrower's propensity to default; that is, there is adverse selection. The latter imperfection implies that default may actually occur in equilibrium, unlike in much of the previous
literature.

For relatively high house prices the commitment problem ensures that the equilibrium is typically characterized by a standard financial accelerator; that is, the borrowing constraints which prevent default become tighter as falling prices reduce the wealth with which agents can collateralize future loans, thereby exacerbating aggregate fluctuations. However, we show that when prices are low, agents will default, which serves as a stabilizing force.

Number of Pages in PDF File: 36

Keywords: Financial accelerator, Default, Collateral, Credit history

JEL Classification: D52, E44, G12, G21, G33

working papers series