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Adverse selection and self-fulfilling business cycles

Jess Benhabib (), Feng Dong and Pengfei Wang

Journal of Monetary Economics, 2018, vol. 94, issue C, 114-130

Abstract: This paper introduces a simple adverse selection problem arising in credit markets into a standard textbook continuous-time real business cycle model. Such adverse selection generates multiple steady states and both local and global indeterminacy, and can give rise to equilibria with probabilistic jumps in credit, consumption, investment and employment driven by Markov sunspots under calibrated parameterizations and fully rational expectations. Introducing reputational effects eliminates defaults and results in a unique but still indeterminate steady state. Finally we generalize the model to firms with heterogeneous and stochastic productivity, and show that indeterminacies and sunspots persist.

Keywords: Adverse selection; Local indeterminacy; Global dynamics; Sunspots (search for similar items in EconPapers)
JEL-codes: E44 G01 G20 (search for similar items in EconPapers)
Date: 2018
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Related works:
Working Paper: Adverse Selection and Self-fulfilling Business Cycles (2016) Downloads
Working Paper: Adverse Selection and Self-fulfilling Business Cycles (2014) Downloads
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