Kiyotaki-Moore model
Encyclopedia
The Kiyotaki–Moore model of credit cycles is an economic model developed by Nobuhiro Kiyotaki
and John H. Moore
that shows how small shock
s to the economy might be amplified by credit
restrictions, giving rise to large output fluctuations
. The model assumes that borrowers cannot be forced to repay their debts. Therefore, in equilibrium, lending occurs only if it is collateralized
. That is, borrowers must own a sufficient quantity of capital
that can be confiscated in case they fail to repay. This collateral requirement amplifies business cycle
fluctuations because in a recession
, the income from capital falls, causing the price of capital to fall, which makes capital less valuable as collateral, which limits firms' investment by forcing them to reduce their borrowing, and thereby worsens the recession.
Kiyotaki (a macroeconomist
) and Moore (a contract theorist
) originally described their model in a 1997 paper in the Journal of Political Economy
. Their model has become influential because earlier real business cycle models typically relied on large exogenous
shocks to account for fluctuations in aggregate
output
. The Kiyotaki-Moore model shows instead how relatively small shocks might suffice to explain business cycle fluctuations, if credit markets are imperfect.
, with different time preference
rates: "patient" and "impatient." The "patient" agents are called "gatherers" in the original paper, but should be interpreted as households that wish to save. The "impatient" agents are called "farmers" in the original paper, but should be interpreted as entrepreneur
s or firm
s that wish to borrow in order to finance their investment
projects.
Two key assumptions limit the effectiveness of the credit market in the model. First, the knowledge of the "farmers" is an essential input to their own investment projects-- that is, a project becomes worthless if the farmer who made the investment chooses to abandon it. Second, farmers cannot be forced to work, and therefore they cannot sell off their future labor to guarantee their debts. Together, these assumptions imply that even though farmers' investment projects are potentially very valuable, lenders have no way to confiscate this value if farmers choose not to pay back their debts.
Therefore, loans will only be made if they are backed by some other form of capital which can be confiscated in case of default
. In other words, loans must be backed by collateral
. Kiyotaki and Moore's paper considers land
as an example of a collateralizable asset
. Thus land plays two distinct roles in the model: (i) it is a productive input, and (ii) it also serves as collateral
for debt.
Hence, impatient agents must provide real estate as collateral if they wish to borrow. If for any reason the value of real estate declines, so does the amount of debt they can acquire. This feeds back into the real estate market, driving the price of land down further (thus, the borrowing decisions of the impatient agents are strategic complements
). This positive feedback
is what amplifies economic fluctuations in the model.
The paper also analyzes cases where debt contracts are set only in nominal terms or where contracts can be set in real terms, and considers the differences between the cases.
, and compared the predictions of his model with observed fluctuations of real housing prices in the United States.
Nobuhiro Kiyotaki
is a Japanese economist and professor at Princeton University especially known for proposing several models that provide deeper microeconomic foundations for macroeconomics, some of which play a prominent role in New Keynesian macroeconomics.-Career:...
and John H. Moore
John Hardman Moore
John Hardman Moore is an economic theorist. He was appointed Professor of Political Economy at the University of Edinburgh in 2000. Previously, in 1983, he was appointed to the London School of Economics, where in 1990 he became Professor of Economic Theory, a position he still holds.- Education...
that shows how small shock
Shock (economics)
In economics a shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors—that is, factors unexplained by economics—which may have an impact on endogenous economic variables.The...
s to the economy might be amplified by credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
restrictions, giving rise to large output fluctuations
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
. The model assumes that borrowers cannot be forced to repay their debts. Therefore, in equilibrium, lending occurs only if it is collateralized
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. That is, borrowers must own a sufficient quantity of capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
that can be confiscated in case they fail to repay. This collateral requirement amplifies business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
fluctuations because in a recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...
, the income from capital falls, causing the price of capital to fall, which makes capital less valuable as collateral, which limits firms' investment by forcing them to reduce their borrowing, and thereby worsens the recession.
Kiyotaki (a macroeconomist
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
) and Moore (a contract theorist
Contract theory
In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...
) originally described their model in a 1997 paper in the Journal of Political Economy
Journal of Political Economy
The Journal of Political Economy is an academic journal run by economists at the University of Chicago and published every two months by the University of Chicago Press. The journal publishes articles in both theoretical economics and empirical economics...
. Their model has become influential because earlier real business cycle models typically relied on large exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
shocks to account for fluctuations in aggregate
Aggregate data
In statistics, aggregate data describes data combined from several measurements.In economics, aggregate data or data aggregates describes high-level data that is composed of a multitude or combination of other more individual data....
output
Output (economics)
Output in economics is the "quantity of goods or services produced in a given time period, by a firm, industry, or country," whether consumed or used for further production.The concept of national output is absolutely essential in the field of macroeconomics...
. The Kiyotaki-Moore model shows instead how relatively small shocks might suffice to explain business cycle fluctuations, if credit markets are imperfect.
Structure of the model
In their model economy, Kiyotaki and Moore assume two types of decision makersAgent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
, with different time preference
Time preference
In economics, time preference pertains to how large a premium a consumer places on enjoyment nearer in time over more remote enjoyment....
rates: "patient" and "impatient." The "patient" agents are called "gatherers" in the original paper, but should be interpreted as households that wish to save. The "impatient" agents are called "farmers" in the original paper, but should be interpreted as entrepreneur
Entrepreneur
An entrepreneur is an owner or manager of a business enterprise who makes money through risk and initiative.The term was originally a loanword from French and was first defined by the Irish-French economist Richard Cantillon. Entrepreneur in English is a term applied to a person who is willing to...
s or firm
Firm
A firm is a business.Firm or The Firm may also refer to:-Organizations:* Hooligan firm, a group of unruly football fans* The Firm, Inc., a talent management company* Fair Immigration Reform Movement...
s that wish to borrow in order to finance their investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
projects.
Two key assumptions limit the effectiveness of the credit market in the model. First, the knowledge of the "farmers" is an essential input to their own investment projects-- that is, a project becomes worthless if the farmer who made the investment chooses to abandon it. Second, farmers cannot be forced to work, and therefore they cannot sell off their future labor to guarantee their debts. Together, these assumptions imply that even though farmers' investment projects are potentially very valuable, lenders have no way to confiscate this value if farmers choose not to pay back their debts.
Therefore, loans will only be made if they are backed by some other form of capital which can be confiscated in case of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
. In other words, loans must be backed by collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. Kiyotaki and Moore's paper considers land
Land (economics)
In economics, land comprises all naturally occurring resources whose supply is inherently fixed. Examples are any and all particular geographical locations, mineral deposits, and even geostationary orbit locations and portions of the electromagnetic spectrum. Natural resources are fundamental to...
as an example of a collateralizable asset
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. Thus land plays two distinct roles in the model: (i) it is a productive input, and (ii) it also serves as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
for debt.
Hence, impatient agents must provide real estate as collateral if they wish to borrow. If for any reason the value of real estate declines, so does the amount of debt they can acquire. This feeds back into the real estate market, driving the price of land down further (thus, the borrowing decisions of the impatient agents are strategic complements
Strategic complements
In economics and game theory, the decisions of two or more players are called strategic complements if they mutually reinforce one another, and they are called strategic substitutes if they mutually offset one another...
). This positive feedback
Positive feedback
Positive feedback is a process in which the effects of a small disturbance on a system include an increase in the magnitude of the perturbation. That is, A produces more of B which in turn produces more of A. In contrast, a system that responds to a perturbation in a way that reduces its effect is...
is what amplifies economic fluctuations in the model.
The paper also analyzes cases where debt contracts are set only in nominal terms or where contracts can be set in real terms, and considers the differences between the cases.
Extensions
The original paper of Kiyotaki and Moore was theoretical in nature, and made little attempt to evaluate the quantitative relevance of their mechanism for actual economies. More recently, Kiyotaki's student Matteo Iacoviello embedded the Kiyotaki-Moore mechanism inside a standard New Keynesian general equilibrium macroeconomic model. For realism, Iacoviello assumed that the collateralizable form of capital corresponds to real estateReal estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
, and compared the predictions of his model with observed fluctuations of real housing prices in the United States.