Overborrowing and Systemic Externalities in the Business Cycle

Overborrowing and Systemic Externalities in the Business Cycle (2008)

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by Javier Bianchi , I Thank Juan Dubra , Bora Durdu , Ro Rebucci

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@MISC{Bianchi08overborrowingand,
    author = {Javier Bianchi and I Thank Juan Dubra and Bora Durdu and Ro Rebucci},
    title = {Overborrowing and Systemic Externalities in the Business Cycle},
    year = {2008}
}

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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 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.

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