A Theory of Credit Cycles under Pandemic

Abstract

We develop a tractable dynamic theory linking endogenous credit cycles with conditions in the labor market, in which a pandemic may cripple credit markets and even cause a credit collapse by freezing the labor supply. We execute the idea in a general equilibrium framework with banks and financially constrained heterogeneous firms. In the static model, a modest pandemic disrupts the credit markets only at the intensive margin by decreasing the labor supply. A worsening pandemic can trigger a credit crisis, followed by a discontinuous sharp fall in aggregate output. By extending to a dynamic general equilibrium setting, we show that this mechanism can generate endogenous boom-bust credit cycles. Credit injection per se cannot adequately stabilize the economy. The lockdown policy combined with subsidizing firms turns out to be an efficient policy package to curb pandemic-induced recession.

Keywords: Endogenous Credit Cycles, Pandemic Induced Recession, Lockdown Policy, Credit Policy

JEL Classification: E31, E32, E41, E51, E52