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 fluctua-tions. 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 via the lending standards channel. 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 about entrepreneurs ’ qual-ity, inferred from such payments, less informative. The early payment required to accomplish screening out the unproductive types thus rises. Because the early payment hurts produc-tive entrepreneurs by lowering their investments, competition among lenders results in the emergence of pooling contracts with no early payment requirement. Low productivity entre-preneurs enter production along with productive types, the composition effect setting off a recession. The opposite happens for low enough values of capital