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 cycles, 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 asymmetry in credit markets that rationalizes these findings and generates endogenous (nontrivial) aggregate productivity fluctuations via the lending standards channel. When the economy is productive (productivity evolves endogenously), signals about entrepreneurs’ quality become endogenously less informative, and consequently, screening out the bad projects becomes more costly. Separating contracts do not survive in equilibrium. Instead, contracts financing a mix of good and bad projects emerge. The composition effect due to both good and bad projects being implemented sets off a recession. The opposite happens at troughs. JEL Codes: E32, E44, D24