Discussion paper // Center for Mathematical Studies in Economics and Management Science 1391
This paper builds models of nonlinear dynamics in the aggregate investment and borrower net worth and uses them to study the causes and nature of endogenous credit cycles. The basic model has two types of projects: the Good and the Bad. The Bad is highly productive, but, unlike the Good, it generates less aggregate demand spillovers and contributes little to improve borrower net worth. Furthermore, it is relatively difficult to finance externally due to the agency problem. With a low net worth, the agents cannot finance the Bad, and much of the credit goes to finance the Good, even when the Bad projects are more profitable than the Good projects. This over-investment to the Good creates a boom and generates high aggregate demand spillovers. This leads to an improvement in borrower net worth, which makes it possible for the agents to finance the Bad. This shift in the composition of the credit from the Good to the Bad at the peak of the boom causes a deterioration of net worth. The whole process repeats itself. Endogenous fluctuations occur, as the Good breeds the Bad, and the Bad destroys the Good. The model is then extended to add a third type of the projects, the Ugly, which are unproductive but easy to finance. With a low net worth, the Good competes with the Ugly, creating the credit multiplier effect; with a high net worth, the Good competes with the Bad, creating the credit reversal effect. By combining these two effects, this model generates intermittency phenomena, i.e., relatively long periods of small and persistent movements punctuated intermittently by seemingly random-looking behaviors. Along these cycles, the economy exhibits asymmetric fluctuations; it experiences a long and slow process of recovery from a recession, followed by a rapid expansion, and possibly after a period of high volatility, plunges into a recession.