Credit constraints that link a private agent’s debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to “overborrow. ” The externality arises because agents fail to internalize the price effects of additional borrowing when the credit constraint binds. We quantify the effects of this inefficiency in a two-sector DSGE model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of 7 and causes the maximum drop in consumption to increase by 10 percentage points.

This paper argues that significant structural differences exist between industrial and emerging market economies. Cyclical fluctuations have been more extreme for the latter group and exacerbated by inappropriately procyclical macroeconomic policies. However, we argue that effective stabilization policies remain feasible for the emerging market economies, so long as these invest in developing a robust domestic institutional infrastructure.

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Credit constraints linking debt to market-determined prices embody a systemic credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to “overborrow. ” This externality arises because private agents fail to internalize the financial amplification effects of carrying a large amount of debt when credit constraints bind. We conduct a quantitative analysis of this externality in a two-sector dynamic stochastic general equilibrium (DSGE) model of a small open economy calibrated to emerging markets. Raising the cost of borrowing during tranquil times restores constrained efficiency and significantly reduces the incidence and severity of financial crises.

Gertler and Karadi (2009) combined unconventional `monetary policy'(i.e., direct lending to nancial intermediation and nancial institutions) in a DSGE framework. First, we estimate their model with UK data using Bayesian estimation techniques. To validate the t of the estimated DSGE model, we provide an evaluation of the model's empirical properties. Then, we analyse the transmission mechanism of the shocks, set to produce a downturn. Finally, we deal with some key issues in business cycle analysis: we examine the empirical importance of nominal, real and nancial frictions and of di erent shocks. Our main ndings are that the data strongly favour a model with nancial frictions for the UK economy; the sharp rise in spread since the recent

This paper builds and compares from a Bayesian perspective two dynamic stochastic general equilibrium (DSGE) models with di erent sources of nancial frictions. The two DSGE models, which are both extensions of Smets and Wouters (2007), are: (i) the SWBGG model, with asymmetric information originating in the demand side of the credit market à la Bernanke et al. (1999); and (ii) the SWGK model with nancial frictions originating in the supply side of the credit market, à la Gertler and Karadi (2011). This paper estimates the two models with Euro Area data. The analysis of the Bayes Factor and the forecasting performance provides evidence in favour of the SWGK model. Since the nancial sectors di er among the two models, so do the nancial shocks and, therefore, the propagation mechanisms. Finally, this paper investigates the predictive power of the two models in forecasting in ationary pressures in the Euro Area.

Abstract: Credit constraints that link a private agent’s debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. The externality arises because agents fail to internalize the debt-deflation effects of additional borrowing when negative income shocks trigger the credit constraint. We quantify the effects of this inefficiency in a two-sector dynamic stochastic general equilibrium model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of seven and causes the maximum drop in consumption to increase by 10 percentage points.