Cycles of Credit Expansion and Misallocation: The Good, the Bad and the Ugly

48 Pages Posted: 28 Oct 2018 Last revised: 2 Nov 2018

See all articles by Feng Dong

Feng Dong

Tsinghua University - School of Economics and Management

Zhiwei Xu

Shanghai Jiao Tong University (SJTU) - Antai College of Economics and Management

Date Written: October 4, 2018

Abstract

The Austrian School of business cycle theory views boom-bust cycles in economic activities as an endogenous consequence of overinvestment driven by excessive credit creation by commercial banks under fractional reserve banking. We formalize the Austrian theory in a general equilibrium model with banks and financially constrained heterogeneous firms. In our model, a moderate credit expansion has a nonmonotonic positive impact on aggregate output, but an excessive credit expansion can trigger an interbank-market crisis and result in a discontinuous sharp fall in aggregate output. In a dynamic setting, this mechanism can generate endogenous boom-bust business cycles despite the absence of adverse shocks.

Keywords: Credit Expansion, Volume-Composition Tradeoff, Financial Risk Capacity, Financial Crisis, Credit Cycles

JEL Classification: E32, E51, E58

Suggested Citation

Dong, Feng and Xu, Zhiwei, Cycles of Credit Expansion and Misallocation: The Good, the Bad and the Ugly (October 4, 2018). Available at SSRN: https://ssrn.com/abstract=3260610 or http://dx.doi.org/10.2139/ssrn.3260610

Feng Dong

Tsinghua University - School of Economics and Management ( email )

School of Economics and Management
Tsinghua University
Beijing, Beijing 100084
China

HOME PAGE: http://fengdongecon.weebly.com

Zhiwei Xu (Contact Author)

Shanghai Jiao Tong University (SJTU) - Antai College of Economics and Management ( email )

No.535 Fahuazhen Road
Shanghai Jiao Tong University
Shanghai, Shanghai 200052
China

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