Credit Expansion and Credit Misallocation

This paper develops a general equilibrium model to analyze the interaction between two sectors with differing degree of financial friction in the context of liquidity injections (credit expansion). We show that if too much liquidity is injected into the economy, overheating can build up in the sector with lower friction, crowding liquidity out of the sector with higher friction. The crowding-out manifests in a self-reinforcing spiral because of feedback between liquidity inflows, asset prices, and collateral values. The paper highlights the effect of financial frictions on the allocation and distribution of liquidity in an economy, demonstrating misallocation of liquidity (credit) in the economy under excessive liquidity injections