The paper investigates the behavior of credit demand and output arising from differences in productive capital sources in economies recovering from an adverse real shock. Beside physical capital, another form of capital – human capital – is available during the catch-up phase. Since a part of new physical capital must be debt-financed, whereas production is risky due to uncertain future total factor productivity, defaults happen with positive probability. The latter can be reduced by partially substituting physical capital for human, at a disutility cost. We ask whether a shift away from risky borrowed physical capital to human capital is able to generate a reduction in aggregate credit losses without too big a loss in output, thereby warranting a specific prudential policy. This question is addressed by means of a dynamic stochastic model with feedback decision rules, for which we develop a full-distribution numerical solution method. The long-term stationary limit distribution of the solution generalizes the steady state notion of deterministic models. Agents that start from relatively “poor” initial states are found to benefit from limits on unsecured borrowing at a very moderate cost in output terms, whereas for “rich” initial states, such limits prove to be largely redundant.
JEL codes: E22, G33, G38, C61, D92
Keywords: Credit, dynamic stochastic equilibrium, human capital, prudential policy, recovery
Issued: December 2016