Cleansing by tight credit: rational cycles and endogenous lending standards

Farboodi, Maryam and Kondor, Peter ORCID: 0000-0001-9797-9291 (2021) Cleansing by tight credit: rational cycles and endogenous lending standards. Financial Markets Group Discussion Papers (843). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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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.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 2021 The Authors
Divisions:	Finance
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations; Cycles E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy G - Financial Economics > G1 - General Financial Markets > G10 - General
Date Deposited:	25 May 2023 08:03
Last Modified:	01 Oct 2024 04:04
URI:	http://eprints.lse.ac.uk/id/eprint/118900

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