Financial Intermediation, Moral Hazard, And Pareto Inferior Trade
A simple two-country model of international trade under uncertainty is considered, where investors choose uncertain projects depending on interest rates, with high rates leading to risky projects. If investment is financed by bond markets, there can be asymmetric equilibria which can be Pareto improved. For some parameter values, investment in one country cannot be financed by the bond market. In this situation, a bank which can monitor the investment choices will improve the welfare in both countries, while giving rise to new problems of information asymmetry
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