Credit frictions and unexpected credit crunches

In this paper I develop a simple model of dynamic general equilibrium similar to the neoclassical growth model, but where credit flows are created by agents stochastically receiving investment opportunities that allow them to create new capital. Hence agents may switch status over time from investors to workers and vice versa. Agents can issue equity up to a given fraction, so they can partially finance their investment costs externally and are in effect borrowing constrained. I characterize steady states and transitional dynamics in this environment and analyze the effects on allocations, asset prices and returns of a sudden, unexpected credit crunch: an exogenous, unanticipated decrease in the maximum fraction of investment costs that can be financed externally. I find that this type of unexpected shock generates a sizeable contraction in output and investment and produces a heterogeneous response in the return on assets, depending on the evolution of agents’ status through time.