Working Paper: CEPR ID: DP2351
Authors: Pietro Reichlin; Paolo Siconolfi
Abstract: We analyse the Pareto optimal contracts between lenders and borrowers in a model with asymmetric information. The model is a generalization of the Rothschild-Stiglitz pure adverse selection problem to include moral hazard with limited liability contracts. Entrepreneurs with unequal ``abilities" borrow to finance alternative investment projects which differ in degree of risk and productivity. We determine the endogenous distribution of projects as functions of the amount of loanable funds, when lenders have no information about borrowers' ability and technological choices. Then, we embed these results in a general equilibrium overlapping generations economy with production and show that, for a wide set of economies, equilibria are characterized by multiple steady states and persistent endogenous cycles such that the average quality of the selected projects is high in recessions and low in booms.
Keywords: financial intermediation; business cycle
JEL Codes: A10; E32; G14; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interest payments on good projects (E43) | proportion of bad projects selected by entrepreneurs (L26) |
| economic booms (E32) | moral hazard and adverse selection issues (D82) |
| interest rates (E43) | selection of investment projects (G11) |
| loanable funds (G21) | selection of investment projects (G11) |
| economic booms (E32) | higher proportion of bad projects (H43) |
| higher proportion of bad projects (H43) | loss of resources (Q32) |
| loss of resources (Q32) | decline in output (E23) |