Are financial frictions important in the transmission mechanism of credit cycle? The case of China

Based on the principal-agent theory, this paper investigates the transmission mechanism of credit cycle in China using the dynamic general equilibrium, and testifies that financial friction plays a very important role in business cycle. Due to the dual-functions of durable capital: productive factor and collateral, credit constraint and capital price interact which,produces the transmission mechanism of credit cycle. Static and dynamic multipliers are the main causes of the financial accelerator effect. We find that capital, debt and price behave in the same direction, but their curves are hump-shaped with different wave amplitudes. Financial frictions significantly affect the transmission mechanism of credit cycle, but with the increase of financial frictions, the volatility of credit cycle becomes smaller at first, then bigger, at last smaller, and the duration of a shock is always going up. The empirical study in China verifies the similarity between data and simulation, and reveals that there is strong correlation between credit market and real economy, which means that government can stabilize the economic growth through controlling the credit market. In order to eliminate the negative effects of financial frictions, government should encourage the financial institutions to provide the constrained firms with the financial support so as to form the stability mechanism of economic growth.