Working Paper

Adverse Selection, Lemons Shocks and Business Cycles

Abstract: Asymmetric information is crucial for understanding the disruption of the supply of credit. This paper studies a dynamic economy featuring asymmetric information and resulting adverse selection in credit markets. Entrepreneurs seek loans from banks for projects, but asymmetric information about entrepreneurs' riskiness causes a lemons problem: relatively safe entrepreneurs do not get funded. An increase in the riskiness of some entrepreneurs raises interest rate spreads, aggravates adverse selection, and shrinks the supply of bank credit. The model calibrated to the U.S. economy generates significant business fluctuations including severe recessions comparable to the Great Recession of 2007-09.

Keywords: Adverse selection; Mechanism design approach; separating contract;

JEL Classification: D82; E32; E44;

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Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2019-04-01

Number: 361

Pages: 38 pages