Endogenous labor supply, borrowing constraint, and credit cycles

We investigate Matsuyama’s Econometrica, 72, pp. 853-84, 2004) model modified only to include endogenous and forward looking labor supply decision. Young agents supply one unit of labor endowment elastically to a competitive labor market. While, old agents of ex-ante identical individuals are divided in equilibrium into depositors and entrepreneurs. Depositors lend funds in the form of interest bearing loans, while entrepreneurs borrow funds in the competitive credit market. We emphasize the interaction between credit and labor markets and show the possibility of occurrence of multiple steady states, local and global indeterminacy, and endogenous fluctuations. When young agents become optimistic about the future deposit rate then they decide to work harder and invest more. Countercyclical borrowing constraint will help agents to fulfill their initial optimistic expectations, because the next period credit volume and deposit rate can increase simultaneously. By conducting global bifurcation analysis, we show that credit cycles can occur through a selffulfilling expectation mechanism. History-versus-expectations considerations can exist and escape from underdevelopment as well as fall into poverty can be a selffulfilling prophecy.