Cleansing by Tight Credit: Rational Cycles and Endogenous Lending Standards

Publication Date
Financial Markets Group Discussion Papers DP 843
Publication Date
Paul Woolley Centre Discussion Papers No 82
Publication Authors

Endogenous cycles are generated by the two-way interaction between lenders’ behavior in the credit market and production fundamentals. When lenders choose credit quantity over quality, the resulting lax lending standards lead to low interest rates and high output growth but the deterioration of future loan quality. When the quality is sufficiently low, lenders change their behavior and switch to tight standards, causing high credit spreads and low growth but a gradual improvement in the quality of loans. This eventually triggers a shift back to a boom with lax lending, and the cycle continues. Lenders fail to internalize that tight lending standards cleanse the economy of low quality borrowers and lead to healthier subsequent booms. Therefore, carefully chosen macro-prudential or counter-cyclical monetary policy often improves the decentralized equilibrium cycle.