Creating Business Cycles Through Credit Constraints

Business cycles appear to be large, persistent, and asymmetric relative to the shocks hitting the economy. This observation suggests the existence of an asymmetric amplification and propagation mechanism, which transforms the shocks into the observed movements in aggregate output. This article demon-strates, in a small open economy, how credit constraints can be such a mechanism. The article also shows, however, that the quantitative significance of the amplification which credit constraints can provide is sensitive to the quantitative specification of the underlying economy (especially factor shares). The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Over the past two centuries, aggregate output in the United States has grown steadily, but not in a straight line; it has fluctuated around its upward trend. These output fluctua-tions have had three key properties: