NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Inefficient Credit Booms

Guido Lorenzoni

NBER Working Paper No. 13639
Issued in November 2007
NBER Program(s):   EFG

This paper studies the welfare properties of competitive equilibria in an economy with financial frictions hit by aggregate shocks. In particular, it shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post. Even though, from a first-best perspective the equilibrium always displays under-borrowing, from a second-best point of view excessive borrowing can arise. The inefficiency is due to the combination of limited commitment in financial contracts and the fact that asset prices are determined in a spot market. This generates a pecuniary externality that is not internalized in private contracts. The model provides a framework to evaluate preventive policies which can be used during a credit boom to reduce the expected costs of a financial crisis.

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Document Object Identifier (DOI): 10.3386/w13639

Published: Guido Lorenzoni, 2008. "Inefficient Credit Booms," Review of Economic Studies, Blackwell Publishing, vol. 75(3), pages 809-833, 07.

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