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    Lecture 8 Freixas-Rochet Cycles PDF

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    MICROECONOMICS OF BANKING Xavier Freixas Jean-Charles Rochet Fourth printing, 1999 © 1997 Massachusets Institute of Technology All rights reserved. No pat of this book may’ be reproduced in any form by any eleeoni fr mechanical means (including photocopying, recording. or information storage and retival) ‘without permission in sting from the publishes. “Tis book was set in Times Roman by Windfall Software using 2¢7EX and was printed and bound inthe United Sates of America. Library of Congress Cataloging-in-Pubication Data reins, Xavier Microeconomics of banking / Xavier Preixas and Jean-Charles Rochet pom. Includes bibliographical references and index ISBN 0.252-06108-7 Tr Banks and banking. 2. Finance—Mithematcal models 3, Microcconomies. 4. Information theory in nance. I. Tide HGI6OL FT 1997 332.1—de2l 97-2007 cP ‘The MIT Press ‘Cambridge, Massachusetts London, England 180 ‘The Macroeconomic Consequences of Financial Imperfections inelastic: K; = K. If the government adopts a stationary policy (B; = B), the dynamic path of equilibrium interest rates is given by ear gt [RAB 1 piv = wena! EEE] = (636) . +B Notice that, absent the bankruptcy constraint, the aggregate asset demand would be Aj(p-41)¥* and the equilibrium interest rate would be constant: Ai(on¥" =K + B= ait RB Moreover, the borrowing policy of the government (which determines B,) ‘would affect only the (nominal) interest rate p,,, and not the output ¥*. Be- cause of the bankruptcy constraint, things are very different here. A positive shock on interest rates at date t can have a persistent effect, even though both the productivity of capital and the supply of financial assets (K, + B,) remain constant, This is easy to deduce from equation 6.35 (or 6.36): if p, increases, the effective production level Y[R(p,)] decreases, which negatively affects the wealth of generation r. As a consequence, the rate of return demanded by this generation for buying the (constant) stock of assets increases. It is also inter- esting to notice that the borrowing policy of the government (represented here by B) has a long-term impact on the aggregate production level, since the latter depends on the steady state interest factor p* determined by the equation Ai(o)A2(0") = K + B. ‘To summarize, the essence of Farmer's (1984) contribution is to point out the complex real effects of financial contracting. Once asymmetric information and limited liability are introduced, Farmer shows that today’s productivity shocks will affect tomorrow's interest rates. AS a consequence, real aggregate variables depend not only on current shocks but also on all the history of the past ones. 6.4.2 Credit Cycles Kiyotaki and Moore (1995) consider an economy in which credit cycles appear because of two ingredients: some firms are credit constrained and they use their productive assets as collateral. ‘The authors show how, borrowing possibilities being limited by collateral, small productivity shocks can trigger credit cycles. Ina perfect capital market, a negative shock on the return of the productive as- set would only make the value of this asset decrease until a new equilibrium is reached, But when loans are collateralized (and firms are credit constrained), the amount borrowed is determined by the value of collateral; therefore the de- crease in the price of the productive asset will also have a negative impact on 181 6.4 Financial Cycles and Fluctuations the firms’ investment. This effect is cumulative: a decrease in the firms’ invest- ment decreases future revenues of firms, their net worth falls, and investment is decreased further until the price of the asset is so low that it starts being sold to firms that are not credit constrained, or used for other purposes This discussion will use a simplified version of the model of Kiyotaki and Moore, inspired by Tirole (1994). The economy is composed of (a large num- ber of) risk neutral infinitely lived agents who seek to maximize the discounted sum of their expected consumptions (i.e., E[7;5 B'Cr]). There are only two goods: a nonstorable physical good used for consumption and production, and a capital good (real estate) used as collateral by borrowers and also as a pro- ductive asset. There are two classes of agents: entrepreneurs who own the technology and the productive asset (say, the land), and lenders who receive endowments of the consumption good. Therefore entrepreneurs have to bor- row all the consumption good they invest in their projects. The technology is of the Leontief type with constant returns to scale: with one unit of the con- sumption good and 2 units of land invested at date ¢, each entrepreneur obtains X units of the consumption good at date t + 1 ‘The use of collateral can be justified in many ways. Still, the simplest one is to use Hart and Moore’s (1994) idea of inalienability of human capital dis- cussed in Chapter 4. In a one-period contract, even if the loan is riskless it must be fully collateralized to prevent renegotiation of the terms of the contract. Assuming that the loan must be fully collateralized means in the present context that the amount of future debt cannot exceed the future value of land. If &, is the amount of land the borrower owns during period t and q;1 is the future price of land (which is perfectly forecasted by lenders), the amount of the loan +b, must be such that the borrower's total liability at date ¢ + 1 (b,(1 +r), where (6.37) Assume this constraint holds with equality, which corresponds to Fisher's idea of credit constrained investment. Assume also that there is an alternative use for land; the land can be lent to another category of agents for other purposes such as residential real estate. ‘The (inverse) demand for residential real estate determines the rental price hy as a function of the total supply of residential real estate. Since the total stock of real estate is fixed, the rental rate h, is an increasing function of the quantity A, of real estate used for production. For simplicity, take a linear specification for this inverse demand function: hy = m(A; + ho). (6.38) It remains to determine A, and the equilibrium price of the asset, qr. 182 The Macroeconomic Consequences of Financial Imperfections Let A denote the total stock of land available, which is assumed to be held by entrepreneurs. Since investment is credit constrained, the quantity A, of land that is used for the productive activity is simply times the total amount that firms are able to borrow (Le., 44+). Consequently, dag ltr Notice therefore that the aggregate borrowing capacity is determined by the future price of land q,41. The last ingredient to introduce before solving for the equilibrium dynamics is the no-arbitrage condition: the net return on land must equal the riskless rate r. This determines the relation between q, and gr+1 Indeed, by buying one unit of land at date ¢ an entrepreneur is able to borrow a quantity q,1/(1 +r) of the consumption good. Investing this in the production process, she obtains a unit retwmn of X ~ (1 +7), provided she dedicates fraction 2 of the land for production. The rest of the land (1 — 43!) is used for rental. Consequently the no-arbitrage condition yields 2 da as x= yet (i= 1) <0 na (639) +r T+r Replacing h, by its value and rearranging terms yields 41 = Ag}. + bist + CLOG) (6.40) with __mho “ler Fora stable cycle of order 2 to obtain, two values gj, 93(gf #4) must be found such that B=Gqt) and gf (43). Itis easy to see that the dynamical system defined by 6.40 has a stable cycle of order 2 under the following conditions (see Figure 6.6): 4ac +4<(b-1)? c> Ht 0. ‘The economic mechanism that generates the cyclical behavior (and the sta- ble cycle ABAB) in the neighborhood of the steady state Ey corresponds to the debt deflation theory described by Fisher in his early contribution. Indeed, starting from E}), assume there is a negative shock on the real estate equilibrium price that was initially g* and becomes qo q, So the negative shock on q* will entail ‘an increase in the real estate price at the next date: gf = 6-! > q* > q3. The cyclical behavior comes from the fact that at the right of q*, @'(q)

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