Working Paper: CEPR ID: DP8131
Authors: Alberto Martin; Filippo Taddei
Abstract: The financial crisis of 2007-08 has underscored the importance of adverse selection in financial markets. This friction has been mostly neglected by macroeconomic models of financial frictions, however, which have focused almost exclusively on the effects of limited pledgeability. In this paper, we fill this gap by developing a standard growth model with adverse selection. Our main results are that, by fostering unproductive investment, adverse selection: (i) leads to an increase in the economy?s equilibrium interest rate, and; (ii) it enerates a negative wedge between the marginal return to investment and the equilibrium interest rate. Under financial integration, we show how this translates into excessive capital inflows and endogenous cycles. We also explore how these results change when limited pledgeability is added to the model. We conclude that both frictions complement one another and argue that limited pledgeability exacerbates the effects of adverse selection
Keywords: Adverse Selection; Credit Market Imperfections; International Capital Flows; Limited Pledgeability
JEL Codes: D53; D82; E22; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adverse selection (D82) | Increase in equilibrium interest rate (E43) |
| Adverse selection (D82) | Inefficiencies in entrepreneurship (L26) |
| Adverse selection (D82) | Excessive capital inflows (F32) |
| Excessive capital inflows (F32) | Negative welfare effects (D69) |
| Adverse selection (D82) | Wedge between marginal return to investment and equilibrium interest rate (E43) |
| Limited pledgeability (G19) | Exacerbates adverse selection (D82) |
| Adverse selection + Limited pledgeability (D82) | Lower average productivity of financed projects (G31) |
| Adverse selection + Limited pledgeability (D82) | Rationing to achieve market clearing (D45) |
| Adverse selection (D82) | Endogenous boom-bust cycles (E32) |
| Adverse selection + Limited pledgeability (D82) | Decreased investment quality (G33) |
| Adverse selection + Limited pledgeability (D82) | Slower capital accumulation (E22) |