Soft budget constraints in a dynamic general equilibrium model

This paper considers an overlapping generations model in which capitalinvestment is financed in a credit market with adverse selection. Lenders´inability to commit ex-ante not to bailout ex-post, together with a wealthyposition of entrepreneurs gives rise to the soft budget constraint syndrome,i.e. the absence of liquidation of poor performing firms on a regular basis.This problem arises endogenously as a result of the interaction betweenthe economic behavior of agents, without relying on political economy ex-planations. We found the problem more binding along the business cycle,providing an explanation to creditors leniency during booms in some Latin-American countries in the late seventies and early nineties.