Amplifying Business Cycles through Credit Constraints

Abstract

Theory suggests that endogenous borrowing constraints amplify the impact of external shocks on the economy. How big is the amplification? In this paper, we quantitatively investigate this question in the context of a dynamic general equilibrium model with borrowing constraints under two alternatives: (1) borrowing constraint endogenously depends on the borrower's net worth (2) borrowing constraint is exogenous. Calibrating our model to the Japanese economy, we find evidence of significant amplification in our impulse responses. Quantitatively applying the model to the Japanese case, we find TFP can significantly account for the Japanese business cycle during the period 1980 to 2000 and the impact is much amplified when we assume that borrowing constraints are endogenously determined.Borrowing constraint; Endogenous; Net worth; Business cycle; Amplification