Political Connections, Discriminatory Credit Constraint and Business Cycle

This paper builds a banking DSGE model based on endogenous loan to value ratios, taking the different relationship between different types of enterprises and banks into account. Due to the political connections between the bank and enterprises, loan to value ratio for favored enterprises (e.g. state-owned enterprises) is endogenously higher than that for non-favored enterprises (e.g. private enterprises), which is called discriminatory credit constraint in this paper. Compared to non-discriminatory credit constraint, we find that discriminatory credit constraint can further amplify the impact of negative technology shocks on output, and reduce the effectiveness of expansionary monetary policy. Empirical evidence from China industrial firms’ data supports our conclusion.