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Overborrowing and Systemic Externalities in the Business Cycle

Bianchi, Javier (2009): Overborrowing and Systemic Externalities in the Business Cycle.

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Abstract

Credit constraints that link a private agent's debt to market-determined prices embody a systemic credit externality that drives a wedge between competitive and (constrained) socially optimal equilibria, which induces private agents to ``overborrow". We quantify the effects of this externality in a two-sector DSGE model of a small open economy calibrated to emerging markets. Debt is denominated in units of tradable goods, and is constrained not to exceed a fraction of income, including nontradables income valued at the relative price of nontradables. The externality arises because agents fail to internalize the price effects of their individual borrowing, and hence the adverse debt-deflation amplification effects of negative income shocks that trigger a binding credit constraint. Quantitatively, the credit externality causes a modest increase in average debt, of about 2 percentage points of GDP, but it triples the probability of financial crises and doubles the average current account and consumption reversals caused by these crises.

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