Bubbly Credit Cycles

Abstract

Canonical macroeconomic and financial models require credit to be equal to its fundamental component, i.e., the net present value of the net flows to creditors. Per this conventional view, credit booms are expected to precede increased flows to creditors. However, data suggests otherwise. To rationalize the novel empirical findings, we develop a model with financial frictions and heterogeneous firms, allowing for the existence of credit bubbles. We show that a positive credit bubble shock raises the aggregate credit and output while depressing the credit’s fundamental component through firms’ precautionary savings.

Keywords: Rational Bubbles, Heterogeneous Firms, Financial Frictions

JEL Classification: D92, E32, E44