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Cleansing by tight credit: rational cycles and endogenous lending standards

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  • Farboodi, Maryam
  • Kondor, Peter
Abstract
Endogenous cycles are generated by the two-way interaction between lenders' behavior in the credit market and production fundamentals. When lenders choose credit quantity over quality, the resulting lax lending standards lead to low interest rates and high output growth but the deterioration of future loan quality. When the quality is sufficiently low, lenders change their behavior and switch to tight standards, causing high credit spreads and low growth but a gradual improvement in the quality of loans. This eventually triggers a shift back to a boom with lax lending, and the cycle continues. Lenders fail to internalize that tight lending standards cleanse the economy of low quality borrowers and lead to healthier subsequent booms. Therefore, carefully chosen macro-prudential or counter-cyclical monetary policy often improves the decentralized equilibrium cycle.

Suggested Citation

  • Farboodi, Maryam & Kondor, Peter, 2021. "Cleansing by tight credit: rational cycles and endogenous lending standards," LSE Research Online Documents on Economics 118900, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:118900
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    References listed on IDEAS

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    1. Fernando Leibovici & David Wiczer, 2023. "Firm Exit and Liquidity: Evidence from the Great Recession," Opportunity and Inclusive Growth Institute Working Papers 074, Federal Reserve Bank of Minneapolis.

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    More about this item

    Keywords

    cleansing role of recession; lending standards; endogenous cycles; adverse selection; information choice;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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