DP10462 Changing Credit Limits, Changing Business Cycles

Author(s): Henrik Jensen, Søren Hove Ravn, Emiliano Santoro
Publication Date: March 2015
Keyword(s): business cycles, capital-market liberalization, capital-market regulation, occasionally non-binding contract constraints
JEL(s): E32, E44
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10462

In the last decades, capital markets across the industrialized world have undergone massive deregulation, involving increases in the loan-to-value (LTV) ratios of households and firms. We study the business-cycle implications of this phenomenon in a dynamic general equilibrium model with multiple credit-constrained agents. Starting from low LTV ratios, a progressive relaxation of credit constraints leads to both higher macroeconomic volatility and stronger comovement between debt and real variables. This pattern reverses at LTV ratios not far from those currently observed in many advanced economies, since credit constraints become non-binding more often. As expansionary shocks may make credit constraints non-binding, while contractionary shocks cannot, recessions become deeper than expansions. The non-monotonic relationship between credit market conditions and macroeconomic fluctuations poses a serious challenge for regulatory and macroprudential policies.