The Perils of Credit Booms∗

Credit booms often cause economic expansions. But some credit booms end in financial crises yet others do not. To find out why, this paper presents a dynamic general equilibrium model of production economies with adverse selection in the financial market. Entrepreneurs can take on short-term collateralized debt and trade long-term assets to finance investment. Funding liquidity can erode market liquidity. High funding liquidity discourages firms from selling their good long-term assets since these good assets have to subsidize lemons when there is information asymmetry. This can cause a liquidity dry-up in the market for longterm assets and even a market breakdown, resulting in a financial crisis. Multiple equilibria can coexist. Credit booms combined with changes in beliefs can cause equilibrium regime shifts, leading to an economic crisis or expansion.