Economic Growth in the Emerging Economies
Financial Crises and Economic Growth
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.
1
Introduction
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: raj15@cornell.edu.
1
basis for economics and most
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.
1
Introduction
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: raj15@cornell.edu.
1
basis for economics and most