Cycles of Credit Expansion and Misallocation: The Good, the Bad and the Ugly

Abstract

We offer a tractable dynamic theory where excessive credit creation by the frictional banking sector may lead to over-investment and then endogenous boom-bust cycles. We formalize the idea in a general equilibrium framework with banks and financially constrained heterogeneous firms. In the static model, a moderate credit expansion has a nonmonotonic positive impact on aggregate output, but an excessive credit expansion can trigger an interbank market crisis and result in a discontinuous sharp fall in aggregate output. By extending to a dynamic setting, we show that this mechanism can generate endogenous boom-bust business cycles despite the absence of adverse shocks.