Which mechanism explains how a credit cycle amplifies economic fluctuations in the presence of financial frictions?

• A. Deteriorating balance sheets raise borrowing costs, reducing investment; deleveraging lowers demand and can propagate a downturn.
• B. Increased government spending automatically stabilizes consumption
• C. Tax cuts always lead to higher inflation
• D. Open market operations always tighten credit conditions

Answer: (A)

When financial frictions are present, access to credit depends on the health of balance sheets. If balance sheets deteriorate, lenders charge higher interest rates and impose tighter credit conditions. That makes it more expensive or harder for firms to borrow for investment and for households to finance spending. As a result, investment falls and consumption declines. This drop in spending lowers aggregate demand, reducing profits and asset values further, which weakens balance sheets even more and pushes credit conditions tighter still. The cycle feeds on itself: worse balance sheets lead to tighter credit, which suppresses demand, which worsens balance sheets, and so on. This self-reinforcing loop is how a credit cycle amplifies economic fluctuations.

Other options miss the mechanism. Automatic government stabilization or constant inflation from tax cuts doesn’t capture the endogenous amplification through balance-sheet–driven credit constraints, and central bank actions aren’t guaranteed to tighten credit in every situation.