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Lemons, Market Shutdowns and Learning

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    I study a dynamic economy featuring adverse selection in financial markets. Investment is undertaken by borrowing-constrained entrepreneurs. They sell their past projects to finance new ones, but asymmetric information about project quality creates a lemons problem. The magnitude of this friction responds to aggregate shocks, amplifying the responses of asset prices and investment. Indeed, negative shocks can lead to a complete shutdown in financial markets. I then introduce learning from past transactions. This makes the degree of informational asymmetry endogenous and makes the liquidity of assets depend on the experience of market participants. Market downturns lead to less learning, worsening the future adverse selection problem. As a result, transitory shocks can create highly persistent responses in investment and output.

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    File URL: https://economicdynamics.org/meetpapers/2010/paper_1098.pdf
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    Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 1098.

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    Date of creation: 2010
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    Handle: RePEc:red:sed010:1098
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    Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

    Web page: http://www.EconomicDynamics.org/
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