Growth and Crisis, Unavoidable Connection?

Periods of economic boom with rapid credit and GDP growth can be followed by sudden busts. In the presence of financial markets imperfections, a simple modification of a neoclassical growth model can fully account for this behavior. I study a growth model for a small open economy where decreasing marginal returns to capital appear after the country has reached a threshold level of development, which is uncertain. Limited enforceability of contracts allows borrowers to default on their debt. Lenders optimally choose to suddenly restrict the supply of credit when the threshold is reached and decreasing marginal returns appear. Borrowers default, and a boom-bust cycle is generated. (Copyright: Elsevier)