Collateral Constraints and the Amplification Mechanism

Macroeconomic models of credit market imperfections have been offered as a theory for how common shocks to the balance sheets of credit constrained firms are amplified through changes in the value of collateral and transmitted as fluctuations in output. This paper clarifies and extends these models by first showing that they are not robust to the introduction of markets which allow these firms to hedge against common shocks. A theory of incomplete hedging is then proposed in which the supply of hedging available in the economy is constrained by the aggregate value of collateral. In aggregate, the capacity of banks and other financial intermediaries to provide finance is limited by the aggregate collateral constraint. We find that the constraint introduces a skewed response of the economy to shocks. While the constraint may not affect activity in many states of the world, if shocks are sufficiently adverse, the constraint binds and financial market imperfections amplify the downturn.