Self-Fulfilling Credit Cycles

This paper argues that self-fulfilling beliefs in credit conditions can generate endogenously persistent business cycle dynamics. We develop a tractable dynamic general equilibrium model in which heterogeneous firms face idiosyncratic productivity shocks. Capital from less productive firms is lent to more productive ones in the form of credit secured by collateral and also as unsecured credit based on reputation. A dynamic complementarity between current and future credit constraints permits uncorrelated sunspot shocks to trigger persistent aggregate fluctuations in debt, factor productivity and output. In a calibrated version we compare the features of sunspot cycles with those generated by shocks to economic fundamentals