Collateral Shocks, Lending Relationships and Economic Dynamics

What are the effects of changing bank lending conditions in a model in which borrowers have
endogenously-persistent credit relationships with lenders? This paper answers this question in a simple
Two-Agent New Keynesian (TANK) setup. Fluctuations in collateral requirements, termed collateral
shocks in this paper, result in a rise in spread, a drop in bank credit and amplification of macroeconomic
volatility. These effects are amplified by presence of lending relationships and are greater at higher
persistence and volatility of the collateral shocks. The results in this paper underscore that credit
relationships matter when collateral shocks hit the economy and a model that assumes away the
existence of these lending relationships, risks underestimating their effects.