the initial shock is amplified due to decreased (increased) investment and production activities as a result of the credit crunch (boom). The following model simply illustrates the ideas above: Consider a firm, which possesses liquid assets such as cash holdings (C) and illiquid but collateralizable assets such as land (A). In order to produce output (Y) the firm uses inputs (X), but suppose that the firm needs to borrow (B) in order to finance input costs. Suppose for simplicity that the interest rate is zero. Suppose also that A can be sold with a price of P per unit after the production, and the price of X is normalized to 1. Thus, the amount of X that can be purchased is equal to the cash holdings plus the borrowing Suppose now that it is costly for the lender to seize firm's output Y in case of default; however, ownership of the land A can be transferred to the lender if borrower defaults. Thus, land can serve as collateral. In this case, funds available to firm will be limited by the collateral value of the illiquid asset A, which is given by This borrowing constraint induces a feasibility constraint for the purchase of X Thus, spending on the input is limited by the net worth of the firm. If firm's net worth is less than the desired amount of X, the borrowing constraint will bind and firm's input will be limited, which also limits its output. As can be seen from the feasibility constraint, borrower's net worth can be shrunk by a decline in the initial cash holdings C or asset prices P. Thus, an adverse shock to a firm's net worth (say an initial decline in the asset prices) deteriorates its balance sheet through limiting its borrowing and triggers a series of falling asset prices, falling net worth, deteriorating balance sheets, falling borrowing (thus investment) and falling output. Decreased economic activity feeds back to a fall in asset demand and asset prices further, causing a vicious cycle. Welfare losses and government intervention : an example from the subprime mortgage crisis We have been experiencing the welfare consequences of the subprime mortgage crisis, in which relatively small losses on subprime assets have triggered large reductions in wealth, employment and output. As stated by Krishnamurthy (2010), the direct losses due to household default on subprime mortgages are estimated to be at most