Grading still hangs over me but teaching is done. So, I finally had time to read Kiyotaki Moore. It’s been on my pile of papers to read for many, many years. But it rose to the top because, first, my PhD teaching allowed me to finally get to Myerson’s bargaining chapter in his textbook and Abreu-Gul’s bargaining with commitment model and, second, because Eric Maskin recommends it as one of his key papers for understanding the financial crisis. So, some papers in my queue were cleared out and Kiyotaki-Moore leaped over several others.
I see why the paper has over 2000 cites on Google Scholar.
The main propagation mechanism in the model relies on the idea that credit-constrained borrowers borrow against collateral. The greater the value of collateral “land” , the greater the amount they can borrow. So, if for some reason next period’s price of land is high, the greater is the amount the borrower can borrow against his land this period. Suppose there is an unexpected positive shock to the productivity of land. This increases the value of land and hence its price. This capital gain increases borrowing. An increase in the value of land increases economic activity. It also increases demand for land and hence the price of land. This can choke off some demand for land. The more elastic the supply of land, the smaller is the latter dampening effect. So there can be a significant multiplier to a positive shock to technology.
(Why are borrowers constrained in their borrowing by the value of their land and rather than the NPV of their projects? Kiyotaki-Moore rely on a model of debt of Hart and Moore to justify this constraint. While Hart-Moore is also in my pile, I did not finally have time to read it. I did note they have an extremely long Appendix to justify the connection between collateral and borrowing! The main idea in Hart Moore is that an entrepreneur can always walk away from a project and hold it up. As his human capital is vital for the project’s success, he will be wooed back in renegotiation. The Appendix must argue that he captures all the surplus above the liquidation value of the land. Hence, the lender will only be willing to lend up to value of collateral to avoid hold up.)
But how do we get credit cycles? As the price of land rises, the entrepreneurs acquire more land. This increases the price of land. They also accumulate debt. The debt constrains their ability to borrow and eventually demand for land declines and its price falls. A cycle. Notice that this cycle is not generated by shocks to technology or preferences but arises endogenously as land and debt holdings vary over time! I gotta think about this part more….