The Japanese Economic Review
Vol. 49, No. 1, March 1998

CREDIT AND BUSINESS CYCLESBy NOBUHIRO KIYOTAKI
London School of Economics and Political Science
This paper presents two dynamic models of the economy in which credit constraints
arise because creditors cannot force debtors to repay debts unless the debts are secured
by collateral. The credit system becomes a powerful propagation mechanism by which
the effects of shocks persist and amplify through the interaction between collateralvalues, borrowers' net worth and credit limits. In particular, when ®xed assets serve as
collateral, I show that relatively small, temporary shocks to technology or wealthdistribution can generate large, persistent ¯uctuations in output and asset prices.
JEL Classi®cation Numbers: E32, E44.

1.

Introduction

In this paper I will explain why I believe that theories of credit are useful forunderstanding the mechanism of business cycles. In the 1980s and 1990s, real businesscycle theory has emerged as a focal point in the business cycle debate. The standard
real business cycle (RBC) model is a competitive economy whose equilibrium
corresponds to the solution of the social planner's problem: the planner chooses anallocation of goods and labour to maximize the expected discounted utility of therepresentative agent subject to the resource constraint. The strength of the RBC
approach has been to show that such a simple, yet fully coherent, dynamic generalequilibrium model can be calibrated to match a surprisingly large number of businesscycle observations, especially aggregate quantities. The RBC model, however, has beenmuch less successful in explaining price movements, either relative or nominal. Indeed,
the RBC theory often neglects the problems of money and credit altogether, by using
the representative agent model.
Moreover, the RBC model needs large, persistent and exogenous aggregate
productivity shocks as a mainspring of ¯uctuations. And I ®nd it dif®cult to identify
such productivity shocks as exogenous events. A majority of the shocks appear to beeither shocks on particular sectors of the economy or shocks on distribution, rather
than shocks on the aggregate productivity itself. For example, the oil shocks appear to
be shocks on distribution between oil producers and oil consumers, and monetaryshocks appear to be shocks mainly on distribution between debtors and creditors.
Also, many shocks do not appear to be large compared with the size of the aggregate
economy. I think that what is missing in the RBC models is a powerful propagation
mechanism by which the effects of small shocks amplify, persist and spread acrosssectors.
In this paper I wish to study how, in theory, the credit system may act as such aThis paper is based on the JEA±Nakahara Prize Lecture presented at the Annual Meeting of theJapanese Economic Association at Waseda University, Tokyo, September 13±14, 1997. I would like tothank Edward Green, Fujiki Hiroshi, Narayana Kocherlakota, FrancËois Ortalo-MagneÂ and Fabrizio Perrifor their thoughtful comments. I would particularly like to thank John Moore, since a large part of thepaper is based on the collaborated work with him. Of course, all the remaining errors are my own.
± 18 ±# Japanese Economic Association 1998
Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK.

N. Kiyotaki: Credit and Business Cycles

propagation mechanism. In particular, when the credit limits are endogenously
determined, I wish to examine how relatively small and temporary shocks ontechnology or wealth distribution may generate large, persistent ¯uctuations inaggregate productivity, output and asset prices.
For this purpose, I shall construct two dynamic models of the economy in which
credit constraints arise because creditors cannot force debtors to repay debts unless thedebts are secured by collateral. At each date, there are two groups of agents:
productive agents and unproductive agents. Both have the technology to invest goodsin the present period to obtain returns in the following period and productive agents
have the technology to achieve a higher rate of return. Over time, some of the present
productive agents become unproductive, and some of the unproductive agents become
productive in the subsequent periods. We will examine questions such as:(1) To what extent does the credit market transfer the purchasing power from
unproductive to productive agents at each date, when credit contracts are dif®cult
to enforce?
(2) How does the distribution of wealth between productive and unproductive agents
interact with the aggregate productivity, output and the value of assets over time?
(3) How does a small, unanticipated temporary shock on the aggregate productivity or
wealth distribution generate large and persistent effects on aggregate output andthe value of assets?
In the basic model of Section 2, the collateral is a proportion of the future returns frompresent investment. In equilibrium, productive agents borrow up to the credit limit anduse their own net worth to ®nance the gap between the amounts invested and borrowed.
The transmission mechanism works as follows. Suppose that, at some date t, all agents
experience a temporary productivity shock which reduces their net worth. Because
productive agents have debt obligations from previous periods, their net worth falls
more severely than does that of unproductive agents. Thus, productive agents cut backmore investment than the decrease of aggregate saving, and the average productivity ofinvestment falls together with the share of investment of productive agents. After date t,
it takes time for the share of net worth of productive agents and the aggregate
productivity to recover through saving and investment. Thus, the temporary productivity
shock leads to persistent decreases in the share of net worth of productive agents, theaggregate productivity and the growth rate of the economy.
In the model of Section 3 a ®xed asset, such as land, is introduced. When it isdif®cult to ensure that debtors repay their debts, the ®xed asset serves as collateralfor loans, in addition to being a factor of production. The credit limits ofproductive agents are determined by the value of collateralized ®xed assets. At thesame time, the asset price is affected by the credit limit. The dynamic interaction
between the credit limit and the asset price turns out to be a powerful propagation
mechanism. When the forward-looking agents expect that the temporary productivity
shock will persistently reduce the aggregate output, investment and marginal
product of the ®xed asset in future, the present land price will fall signi®cantly.
Because land is a major asset in the balance sheet, the balance sheet worsens withthe fall of the land price, especially for productive agents who have outstanding
debt obligations. Thus, the share of investment of productive agents, aggregate
productivity and aggregate investment fall even further, and it takes time for them
± 19 ±# Japanese Economic Association 1998

The Japanese Economic Review

to recover. Through the value of the ®xed asset, therefore, persistence andampli®cation reinforce each other.1)

2.

Basic model: persistence

Consider a discrete-time economy with a single homogeneous good and a continuum of
agents. Everyone lives for ever and has the same preferences; i.e.,!
1Xôâ ln c tô ,
(1)
Et
ô0

where c tô is consumption at date t  ô, ln x is natural log of x, â 2 (0, 1) is discountfactor for future utility, and E t is expectations formed at date t. At each date t, there is
a competitive one-period credit market, in which one unit of goods at date t is
exchanged for a claim to r t units of goods at date t  1.
At each date, some agents are productive and the others are unproductive. The
productive agents have a constant-returns-to-scale production technology:
y t1  áx t ,(2)

where x t is investment of goods at date t and y t1 is output of goods at date t  1. The
unproductive agents have a similar constant-returns-to-scale production technology withlower productivity:y t1  ãx t ,where 1 , ã , á:(3)Each agent shifts stochastically between productive and unproductive statesaccording to a Markov process. Speci®cally, each agent who is productive in thisperiod may become unproductive in the next period with probability ä, and each
unproductive agent may become productive with probability nä. The shifts of the
productivity of individuals are exogenous, and are independent across agents and overtime. Assuming that the initial ratio of population of productive agents tounproductive agents is n:1, the ratio is constant over time.
We assume that the probability of the productivity shifts is not too large:ä  nä , 1:

(A1)

Assumption (A1) is equivalent to the condition that the productivity of each individual
agent is positively correlated between the present period and the next period. We
introduce these recurrent shifts in productivity of an individual agent in order to analyse
how the credit system affects the dynamic interaction between distribution of wealthand productivity.
The production technology is speci®c to each producer. Once a producer has
invested goods at date t, only he has the necessary skill to obtain the full returns
described by the production function at date t  1. Without the skill of the producer
who initiated the investment, other people can obtain only a fraction è of the full
1) The model of the credit-constrained economy with ®xed assets is based on Kiyotaki and Moore(1997a). See also Bernanke and Gertler (1989), Chen (1997), Kiyotaki and Moore (1997b), Scheinkman
and Weiss (1986) and Shleifer and Vishny (1992). Gertler (1988) and Bernanke et al. (1997) are
excellent surveys on the interaction between credit and business cycles.
± 20 ±# Japanese Economic Association 1998

N. Kiyotaki: Credit and Business Cycles

returns. On the other hand, each producer is free to walk away from the production
and from any debt obligations between the dates of investment and harvest with somefraction of the returns. As a consequence, if a producer owes a lot of debt, he may beable to renegotiate with the creditor for a smaller debt before harvesting time.
Assuming that the debtor±producer has strong bargaining power, he can reduce his
debt repayment to a fraction è of the total returns.2) Since the creditor can obtain afraction è of the total returns without the help of debtor±producer, this fraction can bethought of as the collateral value of the investment. Anticipating the possibility of thedefault between dates t and t  1, the creditor limits the amount of credit at date t, sothat the debt repayment of the debtor±producer in the next period b t1 will not
exceed the value of the collateral:b t1 < è y t1 :(4)

Because the productivity of each producer between dates t and t  1 is known to the
public at date t, people have perfect foresight about both debt repayment and output
returns in future (aside from an unanticipated shock).
We assume that the rate of return on investment of productive agents without their
speci®c skill is lower than the return on investment of unproductive agents:èá , ã:(A2)

Assumption (A2) implies that the collateralized return on unit investment is smaller
than the debt repayment on unit borrowing, so that productive agents cannot borrow
unlimited amounts, when the real interest rate is at least as high as the rate of return on
the investment of unproductive agents.
Each individual chooses a sequence of consumption, investment, output and debt
from present to future fc t , x t , y t1 , b t1 g to maximize the discounted expected utility(1), subject to the technological constraints (2) and (3), the borrowing constraint (4)and the ¯ow of funds constraint:c t  x t  y t  b t1 =r t ÿ b t ,(5)taking the initial output and debt as given. Equation (5) says that the expenditures on
consumption and investment are ®nanced by the returns from previous investment andnew debt after repaying the old debt.
The market equilibrium implies that the aggregate consumption and investment of
productive and unproductive agents (C t , C9t , X t and X 9t ) are equal to the aggregate
output of productive and unproductive agents (Y t and Y 9t ):C t  C9t  X t  X 9t  Y t  Y 9t :(6)

By Walras's law, the goods market equilibrium (6) imples that the aggregate value ofdebt of productive agents, B t , is equal to the aggregate credit of unproductive agents.
Before characterizing the equilibrium of our economy, it is helpful to think about
what the economy would look like, if there were no default problem so that there were
no borrowing constraint. Then the productive agent would borrow an unlimited
amount as long as the rate of return on investment exceeded the real interest rate,2) Here there is no issue of reputation, because the producer who walks away from production and debt
can start a new life with a clear record. See Hart (1995) and Hart and Moore (1994, 1997) for more
analysis of default and renegotiation.
± 21 ±# Japanese Economic Association 1998

The Japanese Economic Review

á . r t . Nobody would borrow if the rate of returns were less than the real interest
rate, á , r t . Thus, the equilibrium interest rate would be equal to the rate of return on
investment of productive agents:r t  á:(7)

Then no unproductive agent would invest, and only productive agents would invest. The
aggregate investment of productive agents would be equal to the aggregate saving of theeconomy, which turns out to be equal to a fraction â of aggregate wealth of theeconomy under log utility function of (1):3)
X t  âW t  âY t  âáX tÿ1 :(8)Here, the aggregate wealth of the economy is simply the output from the previous
investment of productive agents.
The important feature of the economy without credit constraint is that aggregate
output and investment do not depend upon the distribution of wealth between
productive and unproductive agents. Given that everyone has the same homothetic
preference for present and future goods, aggregate output, consumption and investment
are at the point on the ef®cient production frontier that is independent of wealthdistribution. The growth rate of aggregate wealth is also independent of wealth distribution:G t  W t1 =W t  áâ:(9)

Now let us examine our economy with the borrowing constraint (4). In order tohighlight the importance of the borrowing constraint, let us assume that the probabilityof a present productive agent becoming unproductive in the next period (ä) is large,
and that the ratio of population of productive to unproductive agents (n) is small:ä.è

áÿãã ÿ èá:ã ã ÿ èá ÿ nèã(A3)

The ®rst two terms on the right-hand side of (A3) are the fraction of collateralized
returns and the proportion of productivity gap between productive and unproductive
agents. The right-hand side is less than one for a small enough n, by (A2). Under (A3),
we can show that the equilibrium real interest rate is equal to the rate of return on
investment of unproductive agents,r t  ã,(10)in the neighbourhood of the steady state. (We shall verify (10) after we describe thecredit constrained equilibrium.)
Productive agents invest by borrowing up to the credit limit, because the rate of
return on their investment exceeds the real interest rate. The investment of the
productive agent becomes:
xt 

yt ÿ b t ÿ c t:
1 ÿ (èá=r t )(11)3) From the ®rst-order condition of consumption-saving choice, we have 1=c t  âr t =c t1 . Together withthe ¯ow of funds constraint, a t1  r t (a t ÿ c t ), where a t is net worth ( y t ÿ b t ), we ®nd that c t is afraction 1 ÿ â of the net worth.
± 22 ±# Japanese Economic Association 1998

N. Kiyotaki: Credit and Business Cycles

Since (èá=r t ) is the present value of collateralized returns from unit investment, thenumerator is the required down payment for unit investment. Equation (11) implies thatthe productive agent uses the net worth minus consumption, y t ÿ b t ÿ c t , to ®nance therequired down payment. Equation (11) captures important features of investment underthe borrowing constraint: the investment of productive agents is an increasing functionof their net worth and productivity á, and is a decreasing function of the real interest
rate r t . From (10), (11) and (4) with equality, the ¯ow-of-funds constraint can be
written as:
y t1 ÿ b t1  (1 ÿ è)áx t  á ( y t ÿ b t ÿ c t ),(12)

where á  [(1 ÿ è)á]=[1 ÿ (èá=ã)] . á is the rate of return on saving for productive
agents, taking account of the leverage effect of debt. Because of the log utility, thesaving of productive agents is a fraction â of the net worth.
Unproductive agents are indifferent between lending and investing by themselves,because the real interest rate is the same as the rate of return on their investment.
Their saving is also a fraction â of their net worth. Then the aggregate lending andinvestment of unproductive agents are determined by the market-clearing condition(6). Since consumption, debt and investment are linear functions of the net worth, we
can aggregate across agents to ®nd the equations of motion of the aggregate wealth(W t ) and the aggregate net worth of productive agents at the beginning of date t (A t ):


âA t
âA t
 ã âW t ÿ
W t1  Y t1  Y 9t1  á
1 ÿ (èá=ã)1 ÿ (èá=ã)(13)
1(A t =W t )âW t , ãâW t  (á ÿ ã)
1 ÿ (èá=ã)A t1  (1 ÿ ä)(Y t1 ÿ B t1 )  nä(Y 9t1  B t1 ) (1 ÿ ä)á âA t  näãâ(W t ÿ A t ):(14)

Equation (13) says that the aggregate wealth is the sum of returns on investment of
productive agents and unproductive agents. The investment of productive agents isequal to their saving times the leverage of debt, while the investment of unproductive
agents is the difference between aggregate saving and the investment of productive
agents. Equation (14) implies that the aggregate net worth of productive agents is thesum of the net worth of those who continue to be productive from the previous period
and the net worth of those who switch from being unproductive to being productive.
The important difference from the previous economy of no credit constraint is that, fora given present aggregate wealth, the aggregate wealth of the next period is anincreasing function of the share of net worth of productive agents, s t  A t =W t .
Intuitively, with the credit constraint, the larger the share of net worth of productive
agents is, the larger is the share of investment of productive agents, and the larger is theaggregate productivity of the economy.
The growth rate of aggregate wealth is also an increasing function of the share of
net worth of productive agents:


1
st :
G t  W t1 =W t  â ã  (á ÿ ã)
(15)
1 ÿ (èá=ã)± 23 ±# Japanese Economic Association 1998

The Japanese Economic Review

The growth rate is lower in the economy with the borrowing constraint than in theeconomy without the borrowing constraint (equation (9)). From (13) and (14), we ®ndthat the share of net worth of productive agents evolves according to:s t1 (1 ÿ ä)á s t  näã(1 ÿ s t ) f (s t ):á s t  ã(1 ÿ s t )(16)

Equation (16) implies that the share of net worth of productive agents monotonicallyconverges to a unique steady-state s from any initial value s0 2 [0, 1] . The steadystate share of net worth of productive agents s solves s  f (s ), and the value lies in
between nä and 1 ÿ ä (see Figure 1).
In order to verify that (10) holds in equilibrium, we only need to check that
unproductive agents invest positive amounts of goods:
X 9t  Y t  Y 9t ÿ C t ÿ C9t ÿ X t  âW t ÿ1
âs t W t . 0,
1 ÿ (èá=ã)(17)

because the interest rate is equal to the rate of return on investment of unproductive
agents, if they invest positive amounts. Using (16), we ®nd that (17) holds in theneighbourhood of the steady state if, and only if, assumption (A3) holds. Intuitively, if
st11

12δ

s*
st11 5 f(st)

nδ

45°
0

s*
FIGURE 1.
± 24 ±# Japanese Economic Association 1998

1st

N. Kiyotaki: Credit and Business Cycles

the turnover rate from the productive state to the unproductive state is large and the
population of productive agents is small, then the share of the net worth of productive
agents is small in the steady state; then, given that the fraction of the collateralized
returns is not too large, aggregate saving is larger than the investment of productive
agents, and unproductive agents end up investing, using their inferior technology.
To understand the dynamics of the economy, it is helpful to consider the impulse
response to an unexpected shock. Suppose that at date t ÿ 1 the economy is in thesteady state: s tÿ1  s and G tÿ1  G . There is then an unexpected shock to the
productivity of every agent; both productive and unproductive agents ®nd that theirreturns at the beginning of date t are (1  Ä) times their expectations. For example,
let us assume that Ä is negative. The productivity shock, however, is temporary. The
productivity of date t investment and thereafter returns to the normal as in (2) and (3).
We assume that the unanticipated temporary productivity shock occurs after the agents
have input their labour, so that it is too late for the debtor±producer to renegotiate asmaller debt. Then the aggregate net worth of productive agents at date t is:
A t  (1 ÿ ä)[1  Ä)áX tÿ1 ÿ B t ]  nä[(1  Ä)ãX 9tÿ1  B t ] (1  Ä)[(1 ÿ ä)áX tÿ1  näãX 9tÿ1 ] ÿ (1 ÿ ä ÿ nä)èáX tÿ1 :(18)

Since productive agents have a net debt in the aggregate (even with the turnover underassumption (A1)), the net worth of productive agents decreases proportionately morethan the aggregate productivity as a result of the leverage effect of the debt. Because
the aggregate wealth decreases in the same proportion as the aggregate productivity, theshare of net worth of productive agents s t decreases at date t. Then the growth rate of
the economy is lower than the steady state between date t and t  1. Moreover, since
the recovery of the share of the net worth of productive agents takes time, according to(16), the growth rate also takes time to recover after the productivity shock at date t.
In contrast, if there were no borrowing constraint, then the growth rate would goback to the steady-state level immediately after date t (see Figure 2). Intuitively, we
can see that the temporary productivity shock worsens the wealth distribution of
productive agents who have debt obligations, and this redistribution lowers theaggregate productivity and the growth rate persistently with credit constraint.
Since our framework does not have money, we cannot analyse the effect ofmonetary policy per se. However, one possible impact of the monetary policy may beconsidered as the unanticipated redistribution of wealth between debtors and creditors.
For example, if the debt is nominal and is not indexed, the unanticipatedly lowerin¯ation redistributes wealth from debtors to creditors. Then the share of net worth of
productive agents decreases and the growth rate will decrease persistently.4)
I will add a few remarks concerning the case in which the turnover rate ofproductive agents is not high enough to satisfy assumption (A3). Then the share of net
worth of productive agents is so large that the borrowing constraint is no longer
binding in the steady state. The steady state is exactly the same as in the economy
without the borrowing constraint. If the negative temporary shock reduces the share of
net worth of productive agents, the growth rate after the date of the shock is
unchanged as long as the shock is not too large. However, if the negative shock is4) Fisher (1933) and Tobin (1980) emphasize the monetary transmission mechanism through theredistribution of wealth between creditors and debtors.
± 25 ±# Japanese Economic Association 1998

The Japanese Economic Review

Gt
αβ
G*

t

t21 t

0

(a) Credit-constrained economy

Gt
αβ

0

t

t21 t
(b) Unconstrained economy
FIGURE 2.

large enough to make productive agents' borrowing constrained and to makeunproductive agents invest at date t, then the growth rate will be lower than the steadystate, until productive agents accumulate enough net worth so that unproductive agentsno longer invest in their less productive technology.

3.

Model with ®xed asset: propagation and persistence

In the basic model of Section 2, there was only one homogeneous good with no ®xed
asset, and all the returns from present investment were realized in the following period.
However, one of the variables that ¯uctuates noticeably over the business cycle is thevalue of ®xed assets, such as land, buildings and machinery. Moreover, when lenders± 26 ±# Japanese Economic Association 1998

N. Kiyotaki: Credit and Business Cycles®nd it dif®cult to force debtors to repay debts, these ®xed assets not only are factors of
production but also serve as collateral for loans. In this section, I introduce the ®xed
asset in order to analyse the interaction between the value of the ®xed asset, credit, andproduction over the business cycle.
There are two substantive modi®cations from the basic model. First, in addition to
the homogeneous goods, we have a ®xed asset, called land. The land does notdepreciate and has a ®xed supply, which is normalized to be one. Productive agentsand unproductive agents use land and investment in goods as inputs to produce thehomogeneous goods; i.e., ó 
1ÿó
kt
xt
,
(19)
y t1  áó1ÿó ó 
1ÿó
kt
xt
,
(20)
y t1  ã
ó1ÿó
where k t is land, x t is investment of goods, and 0 , ã , á; parameter ó 2 (0, 1) is theshare of land in costs of input. The productivity of an individual agent follows the same
Markov process as before. Beside the credit market, there is a competitive spot market
for land, in which one unit of land is exchanged for q t units of goods.
The second substantive modi®cation concerns the borrowing constraint. We assume
that, if the agent who has invested at date t with land k t withdraws his labour
between dates t and t  1, there would be no output at date t  1: there would be only
land, k t . At the same time, each producer is able to walk away from the production
and the debt obligation with some fraction of goods in process between dates t andt  1. Thus, the value of collateral is the value of land, and the creditor limits thecredit so that the debt repayment of the debtor±producer does not exceed the value ofcollateral:b t1 < q t1 k t :(21)

The fraction of collateralized returns è t1  q t1 k t =( y t1  q t1 k t ) is no longer
constant here, but ¯uctuates with the value of land.5)
Each agent chooses a path of consumption, investment, land holding, output anddebt fc t , x t , k t , y t1 , b t1 jt  0, 1, 2, . . .g to maximize the expected utility, subject tothe technological constraints (19) and (20), the borrowing constraint (21) and the ¯owof-funds constraint:c t  x t  q t (k t ÿ k tÿ1 )  y t  b t1 =r t ÿ b t ,(22)taking the initial y0 , b0 and k ÿ1 as given. Equation (22) implies that the expenditure on
consumption, investment and net purchase of land is ®nanced by internal returns fromthe previous investment and outside ®nance by new debt net of repayment of the old
debt. The market-clearing conditions are given by the goods market-clearing (equation(6)) and the land market-clearing:5) Here, we assume that the producer buys land rather than renting it. Because the producer can buy asmuch land as he can rent under the borrowing constraint (21), the producer prefers to buy land in order
to avoid being held up by landlords after he has invested goods on land. (Renegotiation would generate
more complications, if debtor±producer, creditor and landlord were all involved.) The perfect-foresightequilibrium path is the same for buying and renting, except for the impulse response to unanticipatedshocks.
± 27 ±# Japanese Economic Association 1998

The Japanese Economic Review

K t  K9t  1:

(23)

Equation (23) says that the sum of the aggregate land holdings of productive andunproductive agents (K t and K9t ) is equal to the total land supply.
In order to describe the competitive equilibrium, it is again helpful to describe ®rst
the economy without the borrowing constraint. Without the borrowing constraint (21),only productive agents invest in goods and use land. Thus, K t  1, and thecompetitive equilibrium corresponds to an ef®cient allocation, which maximizes theweighted average of utility of productive and unproductive agents, subject to theresource constraint:1ÿó
á X tÿ1:(24)
C t  C9t  X t  Y t  ó1ÿóóThis is a deterministic version of the Brock and Mirman (1972) model. Investment
becomes proportional to output, and the economy is going to converge to the steadystate; i.e.,
X t  (1 ÿ ó )âY t ,(25)á(âY t )1ÿó :
óó

(26)

Y t1 The land price is the present value of the future marginal product of land, which turns
out to be proportional to the present aggregate output and the present aggregate wealthowing to the log utility function:
qt 

â
âó
ó Yt 
W t,
1ÿâ
1 ÿ â  âó

(27)

where W t  Y t  q t is the aggregate wealth at date t. Without the borrowing constraint,
aggregate output, investment and land price do not depend upon the distribution of
wealth.
Let us now analyse our economy with borrowing constraint (21). We continue toassume that the turnover rate of productive agents is relatively high:
ä.

áÿã
:
ã

(A4)

Under assumption (A4), we can show that, in the neighbourhood of the steady statewith a small enough ratio of population of productive to unproductive agents, the realinterest rate is equal to the rate of return on investment of unproductive agents:r t  ãuÿó
t :

(29)

u t  q t ÿ q t1 =r t is the opportunity cost, or user cost, of holding land from date t todate t  1. I shall explain later why the right-hand side of (29) is the rate of return on
investment of unproductive agents, and shall verify (29) after describing theequilibrium.
Productive agents borrow up to the credit limit, because their rate of return on
investment exceeds the real interest rate. The investment of goods and land holding of
the productive agent becomes:± 28 ±# Japanese Economic Association 1998

N. Kiyotaki: Credit and Business Cycles

x t  (1 ÿ ó )( y t  q t k tÿ1 ÿ b t ÿ c t ),
kt 

(30)

ó ( y t  q t k tÿ1 ÿ b t ÿ c t ):q t ÿ (q t1 =r t )(31)

Equation (30) says that the productive agent spends (1 ÿ ó ) fraction of his net worth
after consumption on investment of goods, when he maximizes the return from savingwith Cobb±Douglas production function (19). Equation (31) says that the productive
agent spends ó fraction of his saving to ®nance the difference between the land value,q t k t , and the amount he can borrow against land, q t1 k t =r t . The differenceq t ÿ q t1 =r t is thought of as the down payment required to purchase one unit ofland, which happens to be equal to the user cost of land, u t . With the binding borrowing
constraint, the ¯ow-of-funds constraint of the productive agent is now:y t1  q t1 k t ÿ b t1  y t1  áuÿót ( y t  q t k tÿ1 ÿ b t ÿ ct ),(32)

is the return on saving for the productive agent.
where áuÿót
Unproductive agents have a similar production function as productive agents,
except that the productivity is low. Thus, when the unproductive agent maximizes thereturn from investment, he uses goods and land at the same ratio with the productive
agent, x t :k t  1 ÿ ó :ó =u t , and the rate of return on investment of the unproductive
agent becomes ãuÿót , using land as collateral. Therefore, when (29) holds, theunproductive agent is indifferent between investing and lending. The aggregate landholding of unproductive agents is determined by the market-clearing condition forland, (23).
Both productive and unproductive agents consume 1 ÿ â fraction of their net worth
as a result of their preferences. Thus, the market-clearing condition for goods (6) canbe written as:
W t ÿ q t  (1 ÿ â)W t  (1 ÿ ó )u t =ó ,where W t  Y t  Y 9t  q t :(33)

The left-hand side is the aggregate output, and the ®rst term in the right-hand side is theaggregate consumption, which is equal to a fraction 1 ÿ â of the aggregate wealth. The
second term is the aggregate investment of goods, because the ratio of investment ofgoods to usage of land is 1 ÿ ó : ó =u t for both productive and unproductive agents, andbecause the aggregate land holding is equal to one. Along the perfect-foresightequilibrium path, the aggregate wealth and the share of net worth of productive agents
follow:ÿó
W t1  (áuÿót s t  ãu t (1 ÿ s t ))âW t ,s t1 (1 ÿ ä)ás t  näã(1 ÿ s t ) g(s t ):ás t  ã(1 ÿ s t )

(34)
(35)

Equation (34) says that, along the perfect-foresight equilibrium path, given theaggregate saving of the economy, âW t , the fraction of the net worth of productive
agents earns a rate of return áuÿót , while the fraction of unproductive agents earns a
.
The
law
of motion for the share of net worth of productive
rate of return r t  ãuÿótagents in (35) is very similar to that of the basic model (equation (16)), except that the± 29 ±# Japanese Economic Association 1998

The Japanese Economic Review

ratio of the rates of return on saving by productive and unproductive agents is á:ã here
rather than á :ã.6)
From the de®nition of the user cost of land and equation (29), the land price should
satisfy the dynamic equation:q t  u t  q t1 uót =ã:(36)
The perfect-foresight equilibrium is described by a sequence of fq t , W t , s t , u t jt  0,
1, 2, . . .g, satisfying (33), (34), (35), (36) and the initial conditions:
W 0  Y0  Y 90  q0 ,(37)

s0  [(1 ÿ ä)(Y0  q0 K ÿ1 ÿ B0 )  nä(Y 90  q0 K9ÿ1  B0 )]=W 0 ,(38)

for a given initial value of Y 0 , Y 90 , K ÿ1 , K9ÿ1 and B0 . The value in brackets in (38) is
the aggregate net worth of productive agents, which is the sum of the net worth of those
who continue to be productive and those who newly become productive. The initialvalues of aggregate wealth and the share of net worth of productive agents are both
functions of the initial land price, for given values of historically predeterminedvariables. We also rule out the exploding bubbles in the land price:(A5)
lim E0 (q t =(r0 : r1 . . . r tÿ1 ))  0:
t!1

From (33), (34), (35) and (36), there is a unique steady state, (q , W  , s , u ). In
particular, from (35), we know that the steady-state share of net worth of productive
agents s satis®es g(s )  s 2 (nä, 1 ÿ ä), as in the basic model. Unlike the basicmodel, however, the economy does not grow in the steady state, because the land isthe ®xed factor of production. In order to verify (29), we need only show that
aggregate land holding of unproductive agents is positive:
K9t  1 ÿ K t  1 ÿ ó âs t W t =u t . 0:

(39)

Using the steady-state conditions, inequality (39) holds under assumption (A4) for asmall enough n in the neighbourhood of the steady state.
To examine the dynamics, we solve (33) for u t , and substitute the expression of u t
in (34), (35) and (36) to obtain the dynamical system for fq t , W t , s t g. Then we takelinear approximation of the dynamical system around the steady state. It can be shownthat there are two stable eigenvalues and one unstable one:ã
(1 ÿ ä)á ÿ näã ÿ (á ÿ ã)s
,
where
ë

:
ë, 1 ÿ ó ,â(1 ÿ ó )[ás  ã(1 ÿ s )]ás  ã(1 ÿ s )(40)
The eigenvalue ë 2 (0, 1) is the eigenvalue of the linearized system of (35). The eigenvalue
1 ÿ ó is the same as the eigenvalue of the linearized economy without the credit constraint.
The last eigenvalue is larger than one, and corresponds to explosive paths.
We take the land price to be a jump variable, so that fq t , W t , s t g lie on a two6) Of gross returns on investment of date t, y t1  q t1 k t , for the output alone, the ratio of the
productivities between productive and unproductive agents is á:ã in the economy with land. The ratioof the returns on saving between productive and unproductive agents becomes á:ã through the leverage
effect of the debt under the borrowing constraint (21). In the economy without land, the ratio of therates of return on investment is already á:ã, and the ratio of the rates of return on saving is enlarged toá : ã through leverage.
± 30 ±# Japanese Economic Association 1998

N. Kiyotaki: Credit and Business Cycles

dimensional stable manifold, in order to satisfy the non-exploding condition (A5). For
the linear approximation, this stable manifold, expressed in terms of the deviations
from the steady state, is a plane:(á ÿ ã)s^ t  ì^s t ,^q t  W
where ì 
, (41)(á ÿ ã)s ÿ (1 ÿ ä)á  näã  ã=â(1 ÿ ó )^ t  (X t ÿ X  )=X  . Since ì is positive, the land price should move proand X
portionately more than the aggregate wealth on the stable manifold, if the share of net
worth of productive agents moves in the same direction. Intuitively, if, for example, theshare of net worth of productive agents falls with the aggregate wealth, then therecovery of the aggregate wealth is expected to be slow because of the lower aggregate
productivity resulting from a lower share of investment of productive agents during thetransition. Anticipating a slow recovery of the aggregate wealth and the user cost ofland, the present land price falls proportionately more than the present aggregate wealth.
In contrast, in the economy without a credit constraint, the land price is proportional toaggregate wealth and does not depend on the wealth distribution in (27), because theaggregate productivity is independent of the wealth distribution.
Consider the impact of a small, unanticipated, temporary productivity shock Ä , 0
at date t. At date t ÿ 1, the economy was at the steady state. Using (37), (38) and^ t and ^s t to obtain:(41), we can solve simultaneously for ^q t , W
"

#
1
q
nä
^q t 
1ì (42)
1 ÿ  Ä,ds
W ÿ q
"
#



 K
1
q
nä
q
^t 
1ì 
(43)
1 ÿ  ÿ ì(1 ÿ ä ÿ nä)   Ä,Wds
W ÿ q
s W^s t 
where

1q K 
(1 ÿ ä ÿ nä)   Ä,
d
s W

(44)



q
nä
K
1 ÿ  ÿ (1 ÿ ä ÿ nä)  ,d 1ì ssW ÿ q

and K  is the aggregate land holding of productive agents in the steady state. Equation(42) implies that the land price falls proportionately more than the temporary
productivity shock itself at date t. Without the credit constraint, the land value would
decrease only in the same proportion as the productivity shock and the aggregate output
in (27).7) Equation (43) says the aggregate wealth (which is the sum of aggregate output
7) The land price decreases as much as the temporary aggregate productivity shock without the credit
constraint in (27) owing to the log utility function and the Cobb±Douglas production function. From(24), (25) and (26), the marginal product of land at date t is proportional to Y 1ÿó
, while the realtinterest rate is proportional to Y ÿót , and thus the present value of the marginal product of land at date t
is proportional to Y t . Similarly, the marginal product of land at date t  1 is proportional to Y 1ÿót1 ,whose present value at date t is proportional to Y t1 : Y ót (which in turn is proportional to Y t ). Thus, thepresent value of the marginal product of land at dates t, t  1, t  2, . . . are all proportional to Y t , andtherefore the land price becomes proportional to Y t . If the real interest rate is ®xed, say because of
perfect capital mobility in the small open economy, then the effect of the temporary productivity shockon the land price would be much smaller.
± 31 ±# Japanese Economic Association 1998

The Japanese Economic Review

and land value) also decreases more than the productivity shock in proportion. Equation(44) implies that the share of net worth of productive agents decreases with negative
productivity shock.
Figure 3 explains diagrammatically the dynamic effect of the temporary negative
productivity shock. The plane OABC is the stable manifold (41), and the point E on
this plane is the steady-state equilibrium. When the negative productivity shock hits at
date t, the aggregate net worth decreases, and the net worth of productive agents falls
proportionately more than the aggregate wealth owing to the leverage effect of debt.
Thus, as the direct impact of the productivity shock, the aggregate wealth and the

qt

q*

q′

C

qt

0
E′

Wt
E*

Et
B
st

A

s′

F
D

s*
st
FIGURE 3.
± 32 ±# Japanese Economic Association 1998

W′

Wt
W*

N. Kiyotaki: Credit and Business Cycles

share of net worth of productive agents fall from point D  (W  , s ) to pointF  (W 9, s9). After date t, it takes time for the aggregate wealth and the balance
sheet of productive agents to recover through saving and investment. Then the user
cost of land is expected to continue to be low in dates t, t  1, t  2, . . ..
This anticipated, persistent decline in the user cost in future dates is re¯ected by asigni®cant fall in the land price at date t. The land price falls from q to q9, so thatthe point E9  (W 9, s9, q9) is on the stable manifold. However, the effect does notstop here. Land is a major asset. Thus, the fall in land price at date t further reduces
the aggregate wealth, and particularly the net worth of productive agents who haveoutstanding debts. The decrease in the aggregate wealth and the share of net worth of
productive agents in turn further reduces the land price. Therefore, the economy atdate t settles at point Et  (W t , s t , q t ) on the stable manifold, in which the aggregate
wealth, the share of net worth of productive agents and the land price are all
signi®cantly lower than at the steady state. After date t, the economy will gradually
recover to converge to the steady state along the path Et E .
The basic model of Section 2 was a simple framework to highlight how the shock
has more persistent effects on the growth rate in the credit-constrained economy thanin the unconstrained economy. However, since the dynamical system that characterized
the equilibrium path was not forward-looking, this persistent effect in the future did
not feed back to the present condition.8) In fact, both the aggregate wealth and theshare of net worth of productive agents at the initial date were predetermined by past
investment, except for the direct consequence of the productivity shock. In thissection, I introduce the ®xed asset in order to highlight the interaction between
persistence and ampli®cation. The introduction of the ®xed asset makes theequilibrium system both history-dependent and forward-looking. When the productivity shock is expected to have a persistent impact on the future user cost of the ®xed
asset, the forward-looking agents change the valuation of the ®xed asset signi®cantly
at present. Moreover, since the ®xed asset is a major component of the balance sheet(particularly for productive agents who have outstanding debt obligations), theaggregate wealth and the balance sheet of productive agents change signi®cantly,
which ampli®es the effects of the shock today. Intuitively, the persistence and theampli®cation reinforce each other.9) I hope that this interaction between the value ofthe ®xed asset, credit constraint, balance sheets and investment may shed light on
recent business cycles of the Japanese economy.

8) In general, the consumption-saving choice at present may be affected by how persistent the effects ofthe shock are. But the effect on consumption is generally ambiguous for each level of present wealth,and is absent here because of the log utility function.
9) It is dif®cult to compare the size of the propagation between the basic model and the model with the®xed asset, because the former has endogenous growth and the latter does not. Perhaps a better model
to compare with the model with the ®xed asset is the basic model with decreasing returns to scalerather than constant returns. However, in such a model the aggregation is no longer simple, and wehave to keep track of the entire distribution of wealth and productivity in order to describe theequilibrium. See Ortalo-MagneÂ (1996) for an overlapping-generations model with decreasing-returns-toscale investment technology with ®xed assets, in which the younger generations are credit-constrainedwith smaller wealth, and the older generations are not constrained with larger wealth.
± 33 ±# Japanese Economic Association 1998

The Japanese Economic Review

4.

Conclusion

In this paper I have discussed how theories of credit may be useful for business cycle
studies. In conclusion, I wish to add a few remarks about how theories of money, credit
and banking may be useful for understanding the working of a decentralized economy.
Ever since I ®rst became interested in economics, I have been fascinated by thecoordination of the market economy, which Adam Smith called ``the invisible hand ofGod''. Each of us plays a very specialized role in production and consumption, andrelies critically on the production and consumption of many other people. Yet wheneach person decides his or her production and consumption, each person is relativelysel®sh and has limited knowledge about other people's activities. How is thisenormously interdependent production and consumption of many people coordinatedin the market economy, when the individuals who choose their production andconsumption are sel®sh and short-sighted?
The standard answer to this question is the competitive general equilibrium theory.
Roughly, the argument goes as follows. Even if individual producers and consumers
choose their production and consumption plans sel®shly with limited knowledge about
the others, as long as everyone is looking at the same market prices and theauctioneer adjusts the market prices to equate the demand and supply of all goods, all
the individual plans become mutually consistent and feasible. Moreover, if all the
scarce resources are privately owned and privately consumed, the allocation is ef®cientin the competitive general equilibrium.
Although I think that the competitive general equilibrium theory provides a decent®rst-cut answer, I also think that the standard general equilibrium theory, along theline of Arrow±Debreu, does not capture some important aspects of the decentralized
economy, especially as applied to the dynamic economy. For example, how is theexchange of present goods and of future goods enforced? Suppose that A exchanges
present goods for future goods with B. After A provides present goods to B, how can
A make sure that B will provide goods in future? Arrow±Debreu assumed that theauctioneer has the power to impose an in®nite penalty on B if B does not deliver, andthus can ensure that B will provide the promised goods to the market and then themarket supplies goods to A. But when I start thinking about the problem of money,
credit and banking, I begin to believe that this problem of enforcing intertemporalexchange is at the heart of the problem. Since the Arrow±Debreu model does not
explain the roles of money, credit and banking, in order to analyse these problems, we
obviously need to think about an economy that is more decentralized, an economy
without an auctioneer with overall authority to enforce all the contracts. At the sametime, I now believe that, by developing theories of money, credit and banking, we canunderstand better how mutually dependent production and consumption of numeroussel®sh people are coordinated in the decentralized economy.
Final version accepted October 17, 1997.

REFERENCES
Bernanke, B. S. and M. Gertler (1989) ``Agency Costs, New Worth, and Business Fluctuations'', American
Economic Review, Vol. 79, pp. 14±31.
± 34 ±# Japanese Economic Association 1998

N. Kiyotaki: Credit and Business Cycles
Ð±, Ð± and S. Gilchrist (1997) ``Credit-Market Frictions and Cyclical Fluctuations'', forthcoming in
J. Taylor and M. Woodford (eds.), Handbook of Macroeconomics, Amsterdam: North-Holland.
Brock, W. and L. Mirman (1972) ``Optimal Economic Growth and Uncertainty: Discounted Case'', Journalof Economic Theory, Vol. 4, pp. 479±513.
Chen, N-K. (1997) ``Bank Capital, Borrowers, Net Worth and Business Fluctuation'', Chapter 1 of PhD
thesis, University of Minnesota; mimeo, National Taiwan University, 1997.
Fisher, I. (1933) ``The Debt±De¯ation Theory of Great Depressions'', Econometrica, Vol. 1, pp. 337±57.
Gertler, M. (1988) ``Financial Structure and Aggregate Economic Activity: An Overview'', Journal of
Money, Credit and Banking, Vol. 20, pp. 559±88.
Hart, O. (1995) Firms, Contract, and Financial Structure, Oxford: Oxford University Press.
Ð± and J. Moore (1997) ``Default and Renegotiation: A Dynamic Model of Debt'', Discussion Paper,
London School of Economics; revised version of paper written at Harvard University and London
School of Economics in 1989.
Ð± and Ð± (1994) ``A Theory of Debt Based on the Inalienability of Human Capital'', Quarterly Journalof Economics, Vol. 109, pp. 841±79.
Kiyotaki, N. and J. Moore (1997a) ``Credit Cycles'', Journal of Political Economy, Vol. 105, pp. 211±48.
Ð± and Ð± (1997b) ``Credit Chains'', mimeo, London School of Economics.
Ortalo-MagneÂ, F. (1996) ``Asset Price Fluctuations in a Lifecycle Economy: Do Collateral Constraints
Matter?'' Discussion Paper no. 234, London School of Economics, Financial Market Group.
Scheinkman, J. A. and L. Weiss (1986) ``Borrowing Constraints and Aggregate Economic Activity'',
Econometrica, Vol. 54, pp. 23±45.
Shleifer, A. and R. W. Vishny (1992) ``Liquidation Values and Debt Capacity: A Market Equilibrium
Approach'', Journal of Finance, Vol. 47, pp. 1343±66.
Tobin, J. (1980) Asset Accumulation and Economic Activity: Re¯ections on Contemporary Macroeconomic
Theory, Chicago: University of Chicago Press.

± 35 ±# Japanese Economic Association 1998