Credit Cycles: Experimental Evidence
SAFE Working Paper No. 104
30 Pages Posted: 19 May 2015 Last revised: 1 Oct 2016
Date Written: June 23, 2016
This paper reports that credit cycles emerged in laboratory economies that were not hit by aggregate shocks and in which information about fundamentals was perfect. This main result is in our view puzzling because standard theories predict that no cycles should have occurred in such a basic environment. Subjects could borrow funds in the credit market to invest in the risky project. The equilibrium interest rate equalized credit demand and supply. Among other behavioral biases, we observe that subjects increased their credit demand when they made larger losses in the previous period, consistent with a break-even motive. We find that a simple model of investment enriched with this motive can predict a credit cycle. We also show that the market environment plays a crucial role for the emergence of the cycle, which suggests that markets amplify rather than eliminate irrationality. Overall, our work implies that not only fundamental but also psychological factors can play a role in the emergence of fluctuations in financial markets.
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