Kinks and Gains from Credit Cycles

We examine the welfare cost of business cycles in a small open economy model with an occasionally binding collateral constraint. Aggregate uncertainty affects welfare through two opposing forces shaping households' value function: i) a loss reflecting the concavity of current utility, which stems from both prudence and the kink in debt determination; and ii) an offsetting force driven by precautionary saving, which shifts the distribution of future states away from severe episodes of financial tightness, as implied by the convexity of the continuation value. When the latter dominates, uncertainty is welfare-enhancing relative to the deterministic steady state. These fundamental properties are robust to the presence of pecuniary externalities, alternative timing assumptions for the collateral price, and to an environment in which the borrowing constraint does not bind in the steady state.