The Perils of Credit Booms, July 2015

Abstract: Credit booms often cause economic expansions.But some credit booms end in financial crises and others do not. This paper presents a dynamic macroeconomic model with adverse selection in the financial market to address this issue. Entrepreneurs can take short-term collateralized debt and trade long-term assets to finance investment. Funding liquidity can erode market liquidity. High funding liquidity discourages firms from selling their good long-term assets since these good assets have to subsidize lemons when there is information asymmetry.This can cause a liquidity dry-up in the market for long-term assets and even a market breakdown, resulting in a  financial crisis. Multiple equilibria can coexist. Credit booms combined with changes in beliefs can cause equilibrium regime shifts, leading to an economic crisis or expansion.