Leverage, liquidity and crisis: A simulation study

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Antoine Godin and Stephen Kinsella

We study the interactions of banks and firms within a leverage cycle to understand how capacity utilisation and capital investment interact with funding costs, leverage by banks and firms, and liquidity. We show in a simulation study that when firms can grow and die by becoming insolvent, and when banks can grow and die as their bad debts increase to unsustainable levels, the real economy cycles around a leverage cycle.