Borrowing Capacity, Financial Instability, and Contagion: Case Study of the U.S. Subprime Mortgage Crisis

In this paper we study an agent-based model of economy to investigate the impact of borrowing capacity on financial instability and contagion. We divide an economy into agents that interact via flow of funds and express the financial instability level of each agent as a function of the time derivatives of its wealth, cash inflows, and borrowing capacity. We show that among these factors the borrowing capacity, which itself is determined by other economic constraints, aects the most the financial instability, and it can even cause contagion through feedback loop formed by flow of funds. We use historical time series of the integrated macroeconomic accounts of the United Stated from 1960 to date to verify our conjecture by quantifying the financial instability levels of the agents under dierent level of borrowing capacity and how they aect one another during the period of the 2007-10 U.S. subprime mortgage crisis. Finally shortcomings from the limitations of data collecting practice is addressed along with partial yet compatible results for selected Eurozone countries