Research on
endogenous credit cycles is an increasingly interesting topic in modern macroeconomics
as well as monetary economics. Modeling the relationship between credit
friction and business cycles has been recognized as the crucial channel to
explain the volatility of output in economies (Gertlerand Kiyotaki 2010). This report aims to critically summarize the recent
paper of Gu et al. (2013)
which developed a theory to study endogenous credit cycles.
Gu et.al (2013) developed theoretically dynamic models for studying credit lending, consumption, and production with limited commitment as the primary credit friction that endogenously lead to debt limit. Credit cycles forms through borrowers’ beliefs on future their debt limitations that leads to their decisions on whether renege on current debt based on limited commitment. The setup of the model is based on some strong assumptions of rational expectations and perfect knowledge with infinite horizontal model. There are many periods in the model in which each period comprises two subperiods. There are two kinds of agents including consumers and producers who interact together to impose credit constraints as well as debt limits, and then credit cycles. The results show that agents’ beliefs is play an important role for credit conditions and allocations to change over time to establish dynamic equilibria regardless the holding of fundamentals including deterministic and time invariant factors as usually seen in previous models (Gertler and Kiyotaki 2010). Moreover, they exist in many different forms which lead to multiple steady states. Apparently, this paper has developed the theoretical framework for studying lending at a more advanced level with dynamic study. Particularly, two sub-periods in each period are supposed to consider behaviors of agents which borrow and lend credits.
Conventionally, there have been many studies on the nexus of exogenously small shocks and large output fluctuations through dynamic interactions of credit constraints, collateral assets’ prices and production and investment both theoretically (Kiyotaki and Moore 1997; Bernanke,Gertler, and Gilchrist 1999) and empirically (Christiano,Motto, and Rostagno 2010; Liu, Wang, and Zha 2013). In contrast, this study theoretically contributes to the literature when it studies credit cycles based on an endogenous factor that is limited commitment.
The choice of key driver of credit cycles that leads to macroeconomic fluctuations is also different from study to study. Credit fluctuations can be created and exacerbated by fundamental factors which are deterministic and time invariant (Gertler and Kiyotaki 2010). For instance, Myersons (2012) primarily emphasizes the role of moral hazard in financial intermediations. Liu and Wang (2014) shows that imperfect contract enforcement can lead to the default on loan of firms. Meanwhile, this study found that alternatively other factors rather than fundamental factors can generate cycles when credits markets have frictions. Belief is purely emphasized as a channel which leads to credit cycles when there is limited commitment in credit markets. This finding enormously has a significant contribution to the development of existing literature by driving a new trend for research in credit cycles both theoretically and empirically. Obviously, this study relaxed the role of fundamental shocks in the relationship of credit constraints and macroeconomic fluctuations. Additionally, it modeled the interactions between two kinds of agents including credit lenders and borrowers which is more realistic compared with other studies when incorporating beliefs as a key factor into the model. In addition, this study adds consumption, in addition to production and investment into the model when studies the effects of debt limits. It is different from other studies such as Kiyotakiand Moore (1997).
Martin (2008) also theoretically modeled endogenous credit cycles in a dynamic economy based on adverse selection as a key driver of credit cycles while this paper views changes in beliefs. Therefore, Martin (2008) emphasized the role of asymmetric information. In addition, Martin (2008) connects the exogenous shocks into financial systems in the context of adverse selection economy that is not addressed in this paper. However, the analysis of mechanism in which beliefs functions and creates credit cycles is not clearly described. This is enormously still a “black-box”. Agents’ beliefs is enormously complicated rather than the simple description in this paper based on perfect knowledge as well as perfect information.
In terms of results, credit frictions can lead to multiple equilibria is not new. This result from this paper is similar to that of other studies such as Azariadis and Smith (1998), Farhi and Tirole (2012), and Martin and Ventura (2011). However, this study shows the dynamic interactions between lenders and borrowes over time. Sanches and Williamson (2010) also studied credit cycles but it did not show dynamic models like this study. This study conducts modeling the endogenous debt limit using with limited commitments. This method is also not new. From current literature, we can find the same method from many other studies on this topic such as Kehoe and Levine (1993, 2001), and Alvarez and Jermann (2000).
In this paper externalities were not analyzed. It is different from other studies such as Matsuyama (2013), and Myerson (2012). Moreover, this paper endogenously studied credit cycles while other studies such as Woodford (1986, 1988) analyzed exogenous factors. Apparently, this paper has a remarkable contribution to the literature of credit cycles which is endogenously studied. However, omitting the role of exogenously fundamental shocks in interpreting credit cycles is an important shortcoming in this paper. Obviously, the study of credit cycles which based on the combinations of insightful considerations of both fundamental shocks and endogenous mechanism is really important. However, it is currently a literature gap. Hence, future research on this topic should address this gap.
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