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Economic Theory

, Volume 66, Issue 4, pp 819–861 | Cite as

The perils of credit booms

  • Feng Dong
  • Jianjun MiaoEmail author
  • Pengfei Wang
Research Article

Abstract

We present a dynamic general equilibrium model of production economies with adverse selection in the financial market to study the interaction between funding liquidity and market liquidity and its impact on business cycles. Entrepreneurs can take on short-term collateralized debt and trade long-term assets to finance investment. Funding liquidity can erode market liquidity. High funding liquidity discourages firms from selling their good long-term assets since these good assets have to subsidize lemons when there is information asymmetry. This can cause a liquidity dry-up in the market for long-term assets and even a market breakdown, resulting in a financial crisis. Multiple equilibria can coexist. Credit booms combined with changes in beliefs can cause equilibrium regime shifts, leading to an economic crisis or expansion.

Keywords

Adverse selection Liquidity Collateral Bubbles Credit boom Financial crises Multiple equilibria 

JEL Classification

E2 E44 G01 G20 

Notes

Acknowledgements

We are grateful to an anonymous referee for helpful suggestions to improve the paper. We have benefitted from comments by Hengjie Ai, Wei Cui, Zhen Huo, Nicolas Jacquet, Yang Jiao, Benjamin Moll, Nicola Pavoni, Vincenzo Quadrini, Jose-Victor Rios-Rull, Cheng Wang, Yi Wen, Randy Wright, Jianhuan Xu, Tao Zha, Shenghao Zhu, Fabrizio Zilibotti, as well as participants at the NYU Conference on Multiple Equilibria and Financial Crises, the Fourth HKUST International Workshop on Macroeconomics, the 2015 AFR Summer Institute of Economics and Finance at Zhejiang University, the Stockman Conference at University of Rochester, Tsinghua University, Shanghai University of Finance and Economics, Singapore Management University, Renmin University of China, and Peking University.

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Copyright information

© Springer-Verlag GmbH Germany 2017

Authors and Affiliations

  1. 1.Antai College of Economics and ManagementShanghai Jiao Tong UniversityShanghaiChina
  2. 2.Department of EconomicsBoston UniversityBostonUSA
  3. 3.CICFSSouthwestern University of Finance and EconomicsChengduChina
  4. 4.CEMACentral University of Finance and EconomicsBeijingChina
  5. 5.Department of EconomicsHong Kong University of Science and TechnologyClear Water BayHong Kong

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