Robert A. Jarrowy
August 22, 2011
Abstract This paper constructs a simple yet robust model of …nancial crises and economic growth where …nancial markets a¤ect real economic activity. Financial markets increase real output by facilitating investment through the borrowing/lending of capital. However, the borrowing of capital is risky due to randomness in the …rms’production. Financial crises occur when output and liquid capital are insu¢ cient to meet required loan payments and systemic defaults occur. In this model, a …nancial crisis caused by systemic defaults can shift the economy from an equilibrium with positive borrowing/lending to an equilibrium with no borrowing/lending. In this no-lending equilibrium, neither traditional …scal or monetary policy tools are e¤ective in increasing output. Fiscal and monetary policy can only increase the likelihood of the equilibrium evolving to a borrowing/lending equilibrium.
The fundamental economic activities are production and transportation. Both activities require labor and commodities (capital). Production transforms inputs to outputs which are preferred and transportation moves objects to locations where they can be consumed or used in production. These two economic activities have a common characteristic, they take the passage of time for the transformation to be completed. Therefore, any theory that studies these two activities must necessarily involve a time dimension. The owners of the production and transportation technology, in general, are not the owners of the capital and labor. Hence, an economic transaction is needed to engage in production and transportation. Such transactions are the Helpful comments from Ruoran Gao, Hao Li, Viktor Tsyrennikov, and Liheng Xu are gratefully acknowledged. y Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853. email: email@example.com.
basis for economics and most markets.1 This economic transaction between the owners of the technology and the owners of the factor inputs necessarily involves time as well. For production and transportation, the capital and labor are needed in the beginning of the transformation, before the output is generated. The output generates the resources used to pay the owners of the inputs. Consequently, a contract - a legally binding agreement - is made between the owners of the technology and the owners of the inputs to guarantee payment across time. All contracts involving payment across time have credit risk. This is the risk that one party (side) to the contract will renege, i.e. not ful…ll the contract. This is called default. All contracts, therefore, all economic transactions/markets that involve time necessarily are concerned with credit risk. This is certainly obvious for …nancial markets. In fact, the actual transaction mechanism, the construction and design of a market for an economic transaction with a time dimension always involves an explicit consideration of credit risk. Consequently, understanding credit risk is fundamental to understanding economics in general, and macroeconomics in particular. Credit risk is thus the conduit that links real economy activity to …nancial markets. This linkage is the theme of a recent literature studying the relation between business cycles and …nancial markets (see Bernanke , Bernanke and Gertler ,, Gertler , Bernanke , Carlstrom and Fuerst , Bernanke, Gertler and Gilchrist , Iacoviello , Kiyotaki and Moore , Krishnamurthy , Kiyotaki , Cordoba and Ripoll , Geanakoplos , , , Fostel and Geanakoplos , Cooley, Marimon, Quadrini , Brunnermeier and Pedersen ). Our paper adds to this growing literature by studying the relation between …nancial crises, caused by systemic defaults, and real economic growth. A topic not yet fully explored. Our paper provides a new modeling approach for studying this...