Collateral Constraint and News-driven Cycles

The boom-bust cycles such as the episode of the "Internet bubble" in the late 1990s may be described as the business cycle driven by changes in expectations or news about the future. We show that such news-driven cycles can be reproduced by models with collateral constraint. We assume that an asset with fixed supply ("land") is used as collateral, and firms need to hold collateral to finance their input costs. The latter feature introduces an interaction between the inefficiencies in the financial market and in the factor market. The good news raises the price of land today, which relaxes the collateral constraint. It, in turn, reduces the inefficiency in the labor market. If this force is sufficiently strong, the equilibrium labor supply increases. So do output, investment and consumption. With augmented by adjustment cost of investment, our model also generates procyclical movement in Tobin's Q. We also show that when the news turns out to be wrong, the economy may fall into a recession, instead of simply jumping back to the initial steady state. This is because, when the good news arrives, borrowers sell their land, since they need less land to achieve the desired value of collateral. When the news turns out to be wrong, the land price goes back to its steady state level, and hence the total value of collateral becomes lower than the steady state level. It follows that the financial constraint becomes tighter, which increases the labor market inefficiency, and reduces labor, output, and consumption.