By Zheng Liu, Pengfei Wang and Tao Zha
Previous studies on financial frictions have been unable to establish the empirical significance of credit constraints in macroeconomic fluctuations. This paper argues that the muted impact of credit constraints stems from the absence of a mechanism to explain the observed persistent comovements between housing prices and business investment. We develop such a mechanism by incorporating two key features into a DSGE model: we identify shocks that shift the demand for collateral assets and we allow productive agents to be credit-constrained. A combination of these two features enables our model to successfully generate an empirically important mechanism that amplifies and propagates macroeconomic fluctuations through credit constraints.
Intuitively, it seems natural that credit constraint would make business cycles worse. Yet, it has proven to be really difficult to get anything quantitatively important. Maybe it is because it really does not matter that much, at least in aggregate terms. Or maybe it is that we simply have not yet identified the relevant economic mechanism. This paper suggests one that seems to do the trick.