Credit Traps and Credit Cycles

We develop a simple model of credit market imperfections, in which the agents have access to a variety of investment projects, which differ in productivity, in the investment size, and in the severity of the agency problems behind the borrowing constraints. A movement in borrower net worth can shift the composition of the credit between projects with different productivity levels. The model thus suggests how investment-specific technological change may occur endogenously through credit channels. Furthermore, such endogenous changes in investment technologies in turn affect borrower net worth. These interactions could lead to a variety of nonlinear phenomena, such as credit traps, credit collapse, leapfrogging, credit cycles, and growth miracles in the joint dynamics of the aggregate investment and borrower net worth. JEL Classification Numbers: E32 (Business Fluctuations, Cycles), E44 (Financial Markets and the Macroeconomy), O11 (Macroeconomic Analyses of Economic Development), O16 (Financial Markets, Saving and Capital Investment)