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Market Equilibrium with Limited Liability: The Plausibility of Credit Rationing Due to Adverse Selection

Author

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  • Michael Teit Nielsen

    (Institute of Economics, University of Copenhagen)

Abstract

A model is set up in which firms borrow their entire working capital to finance the production of a good which is sold in a market with a random demand side. Limited liability may prevent a rational expectations equilibrium to exist at a given rate of interest, or it may be the cause of multiplicity of such equilibria. Secondly, if the banks give loans to two different industries there may be adverse selection effects, paving the way for credit rationing as in the model of Stiglitz and Weiss (1981), but it seems that such results occur only for somewhat extreme parameter values. Finally, it is shown that if those conditions are satisfied, the interest rate set by the banks may in some cases move counter-cyclically, but this result seems most plausible when it is the safe sector which is the most sensitive to changes in over-all demand, rather than the risky sector, as is the case in the Stiglitz-Weiss model.

Suggested Citation

  • Michael Teit Nielsen, 1989. "Market Equilibrium with Limited Liability: The Plausibility of Credit Rationing Due to Adverse Selection," Discussion Papers 89-23, University of Copenhagen. Department of Economics.
    • Handle: RePEc:kud:kuiedp:8923
    as

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