Leveraged Financing, Over Investment, and Boom-Bust Cycles

Abstract

It has long been argued in the history of economic thought that over investment through highly leveraged borrowing under elastic credit supply may generate large boombust business cycles. This paper rationalizes this idea in a dynamic general equilibrium model with in…nitely lived rational agents. It shows that dynamic interactions between strong asset-accumulation motives (based on habit formation on the borrower side) and elastic credit supply (based on collateralized lending on the lender side) generate a multiplier-accelerator mechanism that can transform a one-time technological innovation into large and long-lasting boom-bust cycles. Such cycles share many features in common to investment bubbles observed in the history (such as the IT bubble in the 1990s and the 2000s housing bubble.).