Adverse selection and self-fulfilling business cycles

Jess Benhabib, Feng Dong, Pengfei Wang

    Research output: Contribution to journalArticle

    Abstract

    This paper introduces a simple adverse selection problem arising in credit markets into a standard textbook continuous-time real business cycle model. Such adverse selection generates multiple steady states and both local and global indeterminacy, and can give rise to equilibria with probabilistic jumps in credit, consumption, investment and employment driven by Markov sunspots under calibrated parameterizations and fully rational expectations. Introducing reputational effects eliminates defaults and results in a unique but still indeterminate steady state. Finally we generalize the model to firms with heterogeneous and stochastic productivity, and show that indeterminacies and sunspots persist.

    Original languageEnglish (US)
    Pages (from-to)114-130
    Number of pages17
    JournalJournal of Monetary Economics
    Volume94
    DOIs
    StatePublished - Apr 2018

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    Keywords

    • Adverse selection
    • Global dynamics
    • Local indeterminacy
    • Sunspots

    ASJC Scopus subject areas

    • Finance
    • Economics and Econometrics

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