DP11166 Deepening Contractions and Collateral Constraints

Author(s): Henrik Jensen, Søren Hove Ravn, Emiliano Santoro
Publication Date: March 2016
Keyword(s): Business Cycles, credit constraints, Deleveraging, Skewness
JEL(s): E32, E44
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11166

The skewness of the US business cycle has become increasingly negative over the last decades. This finding can be explained by the concurrent increases in the loan-to-value ratios of both households and firms. To demonstrate this point, we devise a DSGE model with collateralized borrowing and occasionally non-binding credit constraints. Easier credit access increases the likelihood that constraints become slack in the face of expansionary shocks, while contractionary shocks are further amplified due to tighter constraints. As a result, busts gradually become deeper than booms. Based on the differential impact that occasionally non-binding constraints exert on the shape of expansions and contractions, we are also able to reconcile a more negatively skewed business cycle with a moderation in its volatility. Finally, our model can account for an intrinsic feature of economic downturns preceded by private credit build-ups: Financially driven expansions lead to deeper contractions, as compared to equally-sized non-financial expansions.