A credit cycle model with market sentiments

This paper extends Matsuyama's endogenous credit cycle model to account for recent findings on the role of credit market sentiments. The benchmark model uses a parsimonious financial friction specification in the form of a pledgeability parameter, which indicates how much of the revenue borrowers can pledge for credit. We endogenize this parameter by introducing behavioral aspects of credit markets. Depending on the current level of net worth the credit market sentiment may change. If a critical net worth threshold is passed, a switch from an optimistic to a pessimistic regime occurs. Lenders’ perception of risk and the pledgeability parameter will vary accordingly. The resulting dynamic law of motion is two-dimensional and discontinuous. We show that switching between beliefs fundamentally affects the stability of the system confirming that changes in credit market sentiments drive volatility. However, we also find instances in which behavioral regime switches have a stabilizing effect.