Do Credit Constraints Amplify Macroeconomic Fluctuations?

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.

5 Responses to Do Credit Constraints Amplify Macroeconomic Fluctuations?

  1. It looks like suddenly everybody is using collateral constraints to explain everything. Of course, this has to do with the current crisis. But does this really explain other recessions? I can think of only two where collateral was clearly important: US now and Japan in the early 1990’s. I have yet to see evidence that collateral mattered for other, “regular” recessions.

    • Zheng Liu says:

      You raised a good point: To what extent do collateral constraints matter for other, “regular” recessions? In the paper, we show that credit constraints help amplify and propagate shocks to housing demand because such constraints build a link between land prices and business fixed investment. So the key transmission mechanism works through comovements between land prices and business investment. In the paper, we report evidence that the comovement is not just limited to the recent recession, but is a general property of the data for the entire sample period starting 1975 (the earliest data point for our land price time series). Casual plots of the housing prices (measured by the Loan Performance National HPI) reveal that housing prices in general declined with investment during business cycle down turns with the exception of the 2001 recession. In particular, the Loan Performance HPI declined by 4-5% in 1982 (June and July) and again by about 5% in 1991. In the 2001 recession, the housing price was essentially flat. Since land prices are more volatile than the price of residential structures (Davis and Heathcote, 2007), the declines in land prices during these other “regular” recessions are more pronounced. Such comovement between land prices and business investment makes collateral constraints matter not just for the most recent recession but (to a lesser extent) for other regular recessions as well.

  2. Agent Continuum says:

    I skimmed the references and there’s no trace of CKM’s BCA paper. (Therein McGrattan et al. argue that most cyclical action is accounted for by depressed TFP and labor input and to a far lesser extent by investment/capital distortions.)

    BCA was some criticism out there but it would be interesting to see why the authors think that it’s worth studying a financial wedge and whether this model can or cannot be reduced to the prototype wedges model in CKM/BCA.

  3. Zheng Liu says:

    The Business Cycle Accounting (BCA) framework proposed by CKM is useful for thinking about reduced-form sources of business cycle fluctuations. Their finding that the TFP wedge and the labor wedge drive most of the fluctuations, however, should not be ground for a priori dismissal of financial frictions. It is entirely possible that the “financial wedge” is not the same as the intertemporal wedge in the BCA framework. For instance, Kiyotaki (1998, Japanese Economic Review) shows that, when the credit constrained are more productive than unconstrained agents, then the resource reallocation from the unconstrained to the constrained raises aggregate TFP. In this case, the financial wedge is in fact a part of the TFP wedge.
    A similar reallocation channel exists in our model. We are currently working on the mapping between our credit constraints and the BCA wedges. Thanks for your nice comments.

  4. M.I. says:

    If the link you focus on is from asset prices to business fixed investment, why do insist on house prices and housing demand? Would it be better to have a better measure of the collateral base of firms? Does commercial real estate (to the extent that it is the only collateral used by businesses) have different time series property than “house prices”?

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