Financial Intermediation as a Source of Aggregate Instability

We consider a simple overlapping generations economy where the behavior of intermediaries, in a market characterized by asymmetric information and moral hazard, may give rise to cyclical equilibria. When capital increases output and savings also increase and therefore more capital will be available in the following period. At the same time, however, the higher supply of of savings leads to a decrease in the deposit interest rate and this will induce intermediaries to decrease the number of firms that are monitored. A larger number of firms will select low quality projects and, because of this, less capital will be produced in the following period. For some parameter values this second effect may prevail over the first one and the stock of capital in period t+1 may actually be lower than the stock of capital in period t. The model provides a rigorous interpretation of the view associated with Hyman Minsky [18], Charles Kindleberger [16], and Henry Kaufman [15], according to which expansions come to an inevitable end because of excessive or ill-considered lending that took place during the boom.