Dynamic Adverse Selection and Belief Update in Credit Markets

We develop a dynamic model of debt contracts with adverse selection and belief updates. In the model, entrepreneurs borrow investment goods from lenders to run businesses whose returns depend on entrepreneurial productivity and common productivity. Entrepreneurial productivity is the entrepreneur's private information, and the lender constructs beliefs about the entrepreneur's productivity based on the entrepreneur's business operation history, common productivity history, and terms of the contract. The model provides insights into the dynamic and cross-sectional relations between firm age and credit risk, persistency of the effects of a temporary productivity shock, cyclical asymmetry of the business cycle, slow recovery after a crisis, and constructive and destructive economic downturns