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Working Paper 2008-014B

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"Excessive Demand and Boom-Bust Cycles"
by Patrick A. Pintus, and Yi Wen

It has long been argued in the history of economic thought that boom-bust business cycles may be driven by over-investment (Tugan-Baranovsky, 1894; and Wicksell, 1906). But how is it possible to sustain over-investment without excessive savings? Tugan and Wicksell’s insights were to dissociate investment from savings so aggregate demand is free to fluctuate around a given level of aggregate supply. This breaking of Say’s Law was achieved through credit financing. However, a potential missing link in this line of arguments is consumption: there is little reason to over-expand production capacity unless consumption is expected to grow. This paper formalizes some of Tugan and Wicksell’s ideas into a dynamic general-equilibrium model where markets clear and Say’s law applies in the aggregate. It is shown that dynamic interactions between persistent consumption demand (based on catching-up-with-the-Joneses preferences on the borrower side) and elastic credit supply (based on collateralized assets on the lender side) generate endogenous boom-bust cycles, which are characterized by over-investment during an expansion and under-investment during a contraction.

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Category > Monetary Policy/Macroeconomics
Author > Yi Wen