Author: Xuewen Liu, Pengfei Wang, Zhongchao Yang

Abstract：We present a rational expectations model of credit-driven crises, providing a new perspective to explain why credit booms can lead to severe financial crises and aftermath slow economic recoveries. In our model economy, banks can operate in two types of business. They are sequentially aware of the deterioration of fundamentals of the speculative business and decide whether to continue credit extension in that business or liquidate capital and move into the traditional business. However, because individual banks face uncertainty about how many of their peers have been aware, they rationally choose to extend credit in the speculative business for a longer time than is socially optimal, leading to an over-delayed crisis and consequently more banks being caught by the crisis. This in turn renders the financial crisis more severe and the subsequent economic recovery slower. Extending to a standard textbook macroeconomic growth setting, our model also generates rich dynamics of economic booms, slowdowns, crashes, and recoveries.

Keywords：Credit extensions，Synchronization，Externality，Economic recoveries

The article was published in the February 2024 issue 152 of "Journal of Financial Economics," which is a Level A reward journal in the academic journal ranking scheme of the Economics and Management School of Wuhan University.

Link: https://www.sciencedirect.com/science/article/abs/pii/S0304405X23001976