Working Paper

Interest Rate Dynamics, Variable-Rate Loan Contracts, and the Business Cycle


Abstract: The interest rate at which US firms borrow funds has two features: (i) it moves in a countercyclical fashion and (ii) it is an inverted leading indicator of real economic activity: low interest rates forecast booms in GDP, consumption, investment, and employment. We show that a Kiyotaki-Moore model accounts for both properties when business-cycle movements are driven, in a significant way, by animal spirit shocks to credit-financed investment demand. The credit-based nature of such self-fulfilling equilibria is shown to be essential: the dynamic correlation between current loanable funds rate and future aggregate economic activity depends critically on the property that the loan has a variable-rate component. In addition, Bayesian estimation of our benchmark DSGE model on US data 1975-2010 shows that movements in investment driven by animal spirits are quantitatively important and result in a better fit to the data than both standard RBC models and Kiyotaki-Moore type models with unique equilibrium.

Keywords: Endogenous Borrowing Constraints; Collateral; Variable-Rate Loans; Multiple Equilibria; Sunspot Shocks;

JEL Classification: E21; E22; E32; E44; E63;

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Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2015-11-04

Number: 2015-32

Pages: 53 pages