Collateral, Credit History, and the Financial Decelerator

Ronel Elul

Senior Economic Advisor and Economist

Revised: March 2007

WP 05-23/R – The author develops a simple model in which financial imperfections can serve to stabilize aggregate fluctuations, and not necessarily aggravate them as in much of the previous literature; they term this the financial decelerator.

A previous version of this working paper was originally published in 2005.

Stabilization can occur in this model because lenders are imperfectly informed as to borrowers’ propensity to default; as a result it is too costly for lenders to impose borrowing constraints that guarantee repayment in every possible eventuality. This allows some borrowers to default when house prices are low, thereby leaving them with more wealth; this then serves as an endogenous stabilizing force.

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