Cycles of Credit Expansion and Misallocation: The Good, the Bad and the Ugly
48 Pages Posted: 28 Oct 2018 Last revised: 2 Nov 2018
Date Written: October 4, 2018
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: Suggested Citation