This paper presents models of endogenous business cycles based on the following idea. Some investments are good, while others are bad. Good investments are like those in the business sector, which create jobs and purchase inputs, thereby generating much aggregate demand spillovers. On the other hand, some investments, like trading and speculation in the commodity and real estate markets, generate little aggregate demand spillovers, even though they may be highly profitable. Furthermore, some of these investments are relatively difficult to finance, because their default risk is high. During the recession, the agents are not rich enough to finance these investments.
Much of the saving thus goes to the business sector, and many businesses are formed. This generates a large demand for labor and other inputs, which benefits other agents as well. As the economy expands, the agents become richer. With an improved net worth, the agents can finance their trading activities. Saving is now redirected from business investment to trading, which have little demand spillovers. At the peak of the boom, this change in the composition of credit and of investment causes a deterioration of the net worth, and the economy plunges into a recession. The whole process repeats itself. Endogenous fluctuations occur because good investment breeds bad investment, which destroys good investment, as in ecological cycles driven by predator-prey or host-parasite interactions.
To capture this general idea in a concrete manner, the models developed below use many specific assumptions, made for the most part to simplify the analysis. Two key specifications of the model should be mentioned. First, the overlapping generations structure is used to model aggregate demand spillovers. More specifically, there are overlapping agents who live for two periods. Each generation earns and saves the wage income in their first period. They use their savings to finance the investment project. Because the project requires the minimum level of investment, they also have to borrow from the credit market. There are two types of investment, the Good and the Bad. When more credit is extended to the Good (business investment), more firms are set up and more jobs are created, which improves the net worth of the younger generation, and helping them to finance their investment projects. When credit is extended for the Bad (trading), it does not create any job for the young; the traders simply hoard and stockpile goods.
Thus the investment in trading activities does not benefit the next generations of the agents. The second key feature is the borrowing constraint, which arises endogenously due to the risk of (potential) defaults. The key condition for endogenous fluctuations is that the difficulty of enforcing repayment is large enough for the credit extended to trading that the agents cannot make the Bad investment when the net worth is low, but small enough that they can when it is high. This means that, in recessions, much of the saving goes to business investment, and as the economy booms, more saving is redirected from business investment to trading. One major advantage of using these specifications is that they make the model simple enough to allow for a global analysis of the nonlinear dynamical system governing the equilibrium trajectory in terms of a few key parameters.
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Good and Bad Investment: An Inquiry into the Causes of Credit Cycles
