Endogenous Credit Cycles

Abstract

We propose an adverse selection framework in which the financial sector has a dual role. It amplifies or dampens exogenous shocks and also generates endogenous fluctuations. We fully characterize constrained optimal contracts in a setting in which entrepreneurs need to borrow and are privately informed about the quality of their projects. Our characterization is novel in analyzing pooling and separating allocations in a context of multi-dimensional screening: specifically, the amounts of investment undertaken and of entrepreneurial net worth are used to screen projects.We then embed these results in a dynamic competitive economy. First, we show how endogenous regime switches in financial contracts may generate fluctuations in an economy that exhibits no dynamics under full information. Unlike previous models of endogenous cycles, our result does not rely on entrepreneurial net worth being counter-cyclical or inconsequential for determining investment. Secondly, the model shows the different implications of adverse selection as opposed to pure moral hazard. In particular, and contrary to standard results in the macroeconomic literature, the financial system may dampen exogenous shocks in the presence of adverse selection.

The global credit boom: Challenges for macroeconomics and policy

“…Modern economic growth theory has recognised the importance of institutions for economic development and now may be the time for macroeconomics to move in this direction. The current crisis has shown, for example, how nancial institutions created remuneration policies that may have rewarded risk taking 30 See, for example, Martin (2008) and the references therein. 31 An interesting recent example in this regard is Christiano et al (2008).…”

A Model of Collateral, Investment, and Adverse Selection

“…As discussed before, the answer to this question depends on the profits that each type of contract yields good entrepreneurs. 11 And this, in turn, depends on the level of entrepreneurial wealth. Consider, for example, the case of pooling contracts.…”

“…In De Meza and Webb and Besanko and Thakor, adverse selection leads to overinvestment. Between the two, the environment studied by Besanko 1 See Martin [11].…”

International capital flows and credit market imperfections: A tale of two frictions

“…In the implications of adverse selection for volatility our model is related to Martin (2008), who also shows how this type of friction can give rise to endogenous cycles. 1 The paper is organized as follows.…”