Business Cycles and Leverage in Collateral Constraints

This paper develops a simple dynamic stochastic general equilibrium model with collateral constraints to explore the business cycle implications of financial leverage. From the model-based experiments, the degree of leverage is shown to be an important factor in amplifying the effects of collateral constraints. This finding suggests that financial leverage may affect the real economy in nonneutral ways in the course of business fluctuations. Moreover, instead of the interactions between investment and collateral price, the endogenous accumulation of collateral asset is shown to be an alternative channel through which the business cycle effects of the collateral constraints are generated. From the model simulations, we find it difficult to have both significant amplification and significant persistence at the same time. This is due to the different response patterns of investment and consumption, which are consistent with the intertemporal optimizing behaviors.