Self-Fulfilling Credit-Market Freezes

Abstract

This paper develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because of their self-fulfilling expectations that other banks will not be lending. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, infusion of capital into financial institutions, direct lending to operating firms by the government, and infusion of capital into financial firms under lending commitment.