In the previous chapters we have focused on the effects of aggregate volatility and aggregate productivity or trade shocks on long-run growth, taking volatility as being largely exogenous.

In this and the following chapters we show how volatility can emerge endogenously, in a world where credit constraints sometimes bind.

Until recently, the dominant paradigm to explain persistent macroeconomic volatility in market economies has been the so- called Real Business Cycles model pioneered by Kydland and Prescott (1982) and by Long and Plosser (1987).

where ε_t is a random noise (independently and identically dis­tributed over time) whose variance measures the magnitude of the productivity shocks and ρ is a parameter that measures the persistence of the shocks over time. Second, the production tech­nology

where F exhibits constant returns to scale with respect to capital (K_t) and labor (Lt). The first two equations describe the demand side of the labor market. The supply side is pinned down by a third element, namely the representative individual's utility for consumption and leisure

where η measures the elasticity of labor supply.

This model provides a very simple explanation for why even small productivity shocks can induce large and persistent out­put fluctuations: suppose the occurrence of a positive productivity

shock. This will increase the relative attractiveness of work relative to leisure, and all the more so when the elasticity of labor supply η is sufficiently close to 1. This in turn will amplify the positive effect of the productivity shock on the equilibrium output Y_t.

There are several problems with this approach. First, for small technological shocks to generate large and persistent fluctuations in aggregate GDP and employment, one needs to assume very large values for the variance of ε_t and a persistence parameter ρ very close to 1.^[VII] Second, to account for the fact that large fluctu­ations in employment occur in practice with little change in real wage, one needs to assume a labor supply elasticity parameter η also very close to 1. But then, how can we explain that volatility has been so much higher in Asia or Latin America over the past three decades when the elasticity of labor supply is higher in the United States? Table 3.1 gives estimates of the income-compensated wage elasticities of labor supply for several Asian countries, Peru, and the United States. The elasticity is highest in the United States, with a value of 0.11. Third, there seem to be many more reces­sions than large negative shocks that could explain them: There is the example of the negative trade shock that occurred in Finland upon the collapse of the Soviet Union in 1991, but it is hard to find large negative productivity shocks after 1975 in LatinAmerica or in Asia. For all of these reasons, the literature on explaining

Table 3.1 Income-compensated wage elasticity of labour supply

macroeconomic volatility have come to the conclusion that credit constraints probably do have a role to play in this story.

The basic intuition for why credit constraints may contribute to volatility is laid out in an important paper by Bernanke-Gertler (1989), henceforth BG, and Bernanke et al.

Kiyotaki and Moore (1997), henceforth KM, show a way of extending the BG insight into a theory of persistent business cycles. In their model, a positive shock to profits raises invest­ment which, in turn, increases the price of collateral. This in turn relaxes borrowing constraints on investors and therefore improves their investment capacity. This in turn amplifies the positive shock on profits. Hence, the possibility of positive serial correlation in aggregate output over time. KM also show that this general equilibrium effect via the price of collateral can generate persistent fluctuations, that is negative serial correlation in aggregate output, in an extended version of their models with lags in the response of investment to changes in borrowing constraints.

In this and the next chapter, we develop an elementary the­oretical framework which generates endogenous and persistent volatility in a growing economy with credit constraints. The basic mechanism is the interaction of credit constraints and endogenous changes in market prices. We begin with a version that is relevant for a closed economy, where the important market price is the interest rate. In the next chapter, we present an alternative ver­sion built around a small open economy, and argue that a similar mechanism operates there, even though the interest rate is fixed by the world capital markets. This is because there are endogen­ous movements in the real exchange rate. We argue that the model can account for a number of observed facts about lending booms and crises in emerging market economies. It also provides addi­tional arguments in favor of countercyclical budgetary policies in less financially developed economies. The remaining part of this chapter is organized as follows. Section 3.1 outlines a simple AK growth model with credit constraints and pecuniary externalit­ies among investors. Section 3.2 defines booms and slumps in the context of the model, and Section 3.3 analyzes the dynamics of the model. Section 3.4 derives sufficient conditions for the existence of a limit cycle and considers the long-run effects of exogenous shocks. Section 3.5 discusses the empirical relevance of the model. Section 3.6 turns the attention to policy analysis and the effects of countercyclical budgetary policies.

3.1