This paper proposes a simple theory of credit cycles that focuses on the role of bank capital and financing frictions. We build a continuous time general equilibrium model of an economy in which banks finance their loans by deposits andequity, while facing issuance costs when they raise new equity. The dynamics of the loan rate and the volume of lending in the economy are driven by the level of aggregate bank capitalization. The model has a unique Markov competitive equilibrium that can be solved in closed form. The explicit solutions facilitate the analysis of the full dynamics of the stochastic equilibrium. This dynamics is ergodic and typically exhibits quasi-cyclical patterns depending on the elasticities of credit demand, the fundamental volatility and the magnitude of issuance costs. We also perform a welfare analysis and show that lending decisions made by banks in a competitive equilibrium are socially inefficient.
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Paul Woolley Research Initiative