Expectation driven business cycles with limited enforcement

We explore the implications of shocks to expected future productivity in a setting with limited enforcement of financial contracts. As in Lorenzoni andWalentin (2007) optimal financial contracts under limited enforcement imply that to obtain external finance firms have to post collateral in terms of liquidation value of the firm. In contrast to earlier real one-sector models, we show that a model with this type of 'collateral constraint' generates an increase in stock prices in response to positive news about future productivity, as well as the other properties of an expectation driven business cycle, that is, an increase in consumption, investment and hours. The positive stock price response is in line with Beaudry and Portier's (2006) empirical results and the emerging standard view of expectation driven booms.