Adverse Selection of Investment Projects and the Business Cycle

In an economy where entrepreneurs with unequal ‘abilities’ face alternative investment projects, which differ in their degree of risk and productivity, we analyse the Nash equilibrium contracts arising from a banks-borrowers game in the context of asymmetric information. We show that, for a particular characterization of the game, one can determine the endogenous distribution of projects and the ‘type’ of contracts (pooling or separating) as functions of the amount of loanable funds. We then apply this game to a general equilibrium aggregative economy with production, populated by overlapping generations of borrowers and lenders. We show that, for a range of parameter values, equilibria are characterized by persistent endogenous cycles.