Endogenous credit dynamics as source of business cycles in the EURACE model

The paper investigates the relationship between the amount of credit money in the economy and the variability of output and prices in the EURACE model. First we examine if the decision about dividends payment by the firms can affect this variability, then we adopt the policy measure of quantitative easing, that has been largely used by the Fed and the Bank of England during the recent crisis, in order to understand its effect on economic instability. Results show the emergence of endogenous business cycles which are mainly due to the interplay between the real economic activity and its financing through the credit market. In particular, the amplitude of the business cycles strongly raises when the fraction of earnings paid out by firms as dividends is higher, that is when firms are more constrained to borrow credit money to fund their activity.

The economic crisis and the crisis of economics The current financial and banking crisis and the subsequent severe economic recessions have caused a crisis of confidence in the science of Economics.
Most economists have been unable to forecast timely the crisis and even to devise helpful policies at its beginning.
The Nobel Laureate Paul Krugman recently feared that most macroeconomics of the past 30 years was "spectacularly useless at best, and positively harmful at worst" (The Economist, July 16 th 2009).   With quantitative easing (QE), the central bank purchases government bonds using money it creates from nothing (fiat money), and so expands its balance sheets.

Validation rules
Balance sheet accounting identities can be devised across agents and used to validate the model.

Monetary aggregates and invariants
In the EURACE model we have a key monetary invariant:

Policy experiments
The computational experiments aims to investigate the overall performance of the EURACE economy with respect to two different and alternative fiscal and monetary policies:

Remarks (I)
The credit money supplied by the banking system is the source, together with the fiat money supplied by the central bank, of the endowment of liquid resources held by both the private sector (households, firms and banks) and the public sector (government and central bank).
An increase (higher d) in the demand for credit by firms, if supplied by banks, then increases the amount of liquid resources in the economy.

Remarks (II)
Higher inflation and wage rates are associated to higher values of d Higher inflation rates for higher values of d can not be directly explained according to the quantity theory of money, i.e. due to the higher amount of liquidity in the economy. This because prices are not set by a fictitious Walrasian auctioneer at the cross between demand and supply, but are set by firms, based on their costs, which are labor costs, capital costs and debt financing costs.
Higher credit money means higher debt and higher debt financing costs, thus again higher price inflation through the cost channel.

Output variability
The raising of output variability for higher d values is related to the higher debt load of firms (more bankruptcies) In the first half of the simulation a QE policy seems to stabilize the economy, probably because firms are not subject to a strong fiscal pressure and can afford to pay their debts In the long run: the high amount of money tends to increment the economic fluctuations in the case of QE, while fluctuations don't change in the case of FT

Conclusions
The EURACE economy shows endogenous business cycles and long-run growth Interdependence between real and nominal variables even in the long-run Firms financial fragility, firms bankruptcies and the credit channel are at the heart of this interdependence Policy outcomes: low values of d (financial fragility of firms is low given that they mostly use internal funding to finance their investments) QE policy seems able to improve real economic performance high values of d QE and FT policies give indistinguishable real outcomes Thi probably because of the high level of credit money in the economy that may act as a substitute of the central bank fiat money of the QE case