Leveraged borrowing and boom–bust cycles

Investment booms and asset “bubbles” are often the consequence of heavily leveraged borrowing and speculations of persistent growth in asset demand. We show theoretically that dynamic interactions between elastic credit supply (due to leveraged borrowing) and persistent credit demand (due to consumption habit) can generate a multiplier–accelerator mechanism that transforms a one-time productivity or financial shock into large and long-lasting boom–bust cycles. The predictions are consistent with the basic features of investment booms and the consequent asset-market crashes led by credit expansions.

► We show that collateral constraints and consumption habits generate credit cycles. ► The modelʼs predictions accord with the basic features of documented credit booms. ► Our main results remain under financial shocks and in extensions of the model.