Credit Cycles with Renegotiation

The significant amplification effect of collateral constraints in Kiyotaki and Moore (1997) for adverse shocks depends on the assumption that there is no default ex post, even when the outstanding debt is larger than the value of collateral assets. We show that allowing for explicit default eliminates the dynamic amplification effects in their setup. When there is specificity in the use of productive assets, borrowers will prefer to keep them. This creates a wedge between the inside and outside value of assets setting the stage for bargaining over debt repayments. In this case we do observe amplification effects for moderate shocks, while for larger shocks debt renegotiation dampens amplification. The association found between the degree of asset specificity and the form and intensity of the financial accelerator of economic downturns is consistent with features of observed behavior in some macroeconomic crises. An empirical test of the model’s transmission mechanism is presented.