Lemons Markets and the Transmission of Aggregate Shocks

I study a dynamic economy featuring adverse selection in asset markets. Borrowingconstrained entrepreneurs sell past projects to finance new investment, but asymmetric information creates a lemons problem. I show that this friction is equivalent to a tax on financial transactions. The implicit tax rate responds to aggregate shocks, amplifying the response of the real economy and generating cyclical variation in various measures of liquidity. Financial markets are fragile, volatile and occasionally shut down entirely. The extent to which this instability is related to real economic variables is an important open question for macroeconomics. In this paper I develop a model of financial imperfections to explain how instability can result from macroeconomic shocks and in turn amplify and propagate them. I focus on one specific financial market imperfection: asymmetric information about the quality of assets. There are several reasons for this focus. First, both in theory (Hart and Moore 1994, Kiyotaki and Moore 1997) and in practice, assets of various kinds are extensively used to enable intertemporal transactions. If there is asymmetric information about asset qualities, which is a natural assumption, this has the potential to interfere with a large subset of financial transactions. Second, asymmetric information is a central concern in corporate finance. Following Myers and Majluf (1984), asymmetry of information between firm managers and their outside investors is seen as a key determinant of firms’ capital structure. Third, ∗I am deeply indebted to George-Marios Angeletos, Ricardo Caballero, Bengt Holmström and especially Iván Werning for their invaluable guidance. I also thank Daron Acemoglu, Sergi Basco, Francisco Buera, Mart́ın Gonzalez-Eiras, Guido Lorenzoni, Monika Piazzesi, Krishna Rao, Julio Rotemberg, Martin Schneider, Jean Tirole, Robert Townsend and participants at the MIT Macroeconomics Lunch, Theory Lunch and International Breakfast, as well a various seminar participants. Correspondence: Department of Economics, Stanford University. 579 Serra Mall, Stanford, CA, 94305. Email: [email protected]