Overborrowing and Systemic Externalities in the Business Cycle Under Imperfect Information

Abstract

We relax the perfect information assumption in a small open economy with collateral constraints. Under such a condition, households observe income growth but do not perceive whether the underlying shocks are permanent or transitory. Further, the likelihood and severity of financial crises are increased by the interaction between the information friction and a pecuniary externality that emerges when households use an asset valued at market prices as collateral. Due to a more significant welfare loss, the optimal tax to restore constrained efficiency is six times larger than under perfect information.

Keywords: Overborrowing, macroprudential policy, information frictions, financial frictions

JEL Classification: D62, D84, E44, F32, F38, F41