Self-Fulfilling Credit Crunches
Posted: 17 Jul 2017
Date Written: July 10, 2017
This paper develops a model of a self-fulfilling credit crunch. The model features three types of agents: investors, entrepreneurs and dealers. Investors and entrepreneurs use their labour to produce capital that is traded in a perfectly competitive market and used by entrepreneurs to produce output. Dealers purchase capital and provide loans to entrepreneurs. Entrepreneurs face a trade-off between selling their capital in the market and investing it in a risky project, which is exploited by dealers to screen out high- from low-quality projects. For a specified set of parameters, exactly two equilibria exist. In the good equilibrium, the price of capital is high, entrepreneurs are credit unconstrained and capital production is efficient, whereas in the bad equilibrium, the price of capital plunges, entrepreneurs are credit constrained and capital production is inefficient.
Keywords: capital, leverage, adverse selection, rational expectations, credit crunch
JEL Classification: D82, E30, E44, E58, G01, G21
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