Information Asymmetries and an Endogenous Productivity Reversion Mechanism

Several studies among recent empirical work have suggested that the systematic behavior of lending standards over the business cycle, with laxer standards applied during expansions and tighter standards applied during recessions, may be responsible for driving economic fluctuations. We build a dynamic screening model with informational asymmetries in credit markets that rationalizes these findings and generates endogenous fluctuations of total output and productivity. When the capital stock is high, which evolves endogenously, liquidity is high for all types of producers, allowing even the unproductive type to meet the early payments on the loan, and thus making signals inferred from such payments less informative. The cost that accomplishes successful screening thus rises, resulting in the emergence of pooling contracts which allow financing of low productivity entrepreneurs. The composition among capital producers then sets off a recession. The opposite happens at troughs.