Financial crises and economic growth

•A dynamic model of economic production and consumption is built with a financial market for loans, where there can be systemic defaults.•Two types of equilibrium are shown to exist: a normal equilibrium and a no lending equilibrium.•Comparative statics of the equilibrium interest rates, both risky and riskless, are derived.•Equilibrium dynamics are characterized, both local and global.•Fiscal, monetary, and bank regulatory policy is discussed in the context of the model.

This paper constructs a simple yet robust model of financial crises and economic growth where financial markets affect real economic activity. Financial markets increase real output by facilitating investment through the borrowing/lending of capital. However, the borrowing of capital is risky due to randomness in the firms’ production. Financial crises occur when output and liquid capital are insufficient to meet required loan payments and systemic defaults occur. In this model, a financial crisis caused by systemic defaults can shift the economy from an equilibrium with positive borrowing/lending to an equilibrium with no borrowing/lending. In this no-lending equilibrium, neither traditional fiscal or monetary policy tools are effective in increasing output. Fiscal and monetary policy can only increase the likelihood of the equilibrium evolving to a borrowing/lending equilibrium.