Adverse Selection and the Accelerator

This paper reexamines the relationship between financial market imperfections and economic instability. I present a model in which financial accelerator effects come from adverse selection in credit markets. Unlike other models of the financial accelerator, the model I present has the potential to stabilize the economy rather than destabilize it. The stabilizing forces in the dynamic model are closely related to forces that cause overinvestment in static models. Consequently, the stabilizing properties of the model are not specific to adverse selection but rather are present in any environment in which credit market distortions cause overinvestment. When investment projects are equity financed, or when contracts are written optimally, the only equilibria that emerge are stabilizer equilibria. Thus, stabilizing outcomes are more robust in this model. Finally, the empirical distinction between accelerator equilibria and stabilizer equilibria is subtle. Many statistics used to test for financial accelerators are observationally equivalent in stabilizer equilibria. JEL No: E22, E32, E44, G14 Christopher House University of Michigan Department of Economics 238 Lorch Hall Ann Arbor, MI 48109-1220 [email protected] I thank John Leahy, Russell Cooper, Simon Gilchrist, Robert Barsky, Matthew Shapiro, and Jeff Miron for comments, insights and suggestions. © 2002 by Christopher L. House. All rights reserved.