Optimal Interventions in Markets with Adverse Selection
30 Pages Posted: 1 Mar 2010 Last revised: 20 Aug 2021
Date Written: February 2010
We characterize cost-minimizing interventions to restore lending and investment when markets fail due to adverse selection. We solve a mechanism design problem where the strategic decision to participate in a government's program signals information that affects the financing terms of non-participating borrowers. In this environment, we find that the government cannot selectively attract good borrowers, that the efficiency of an intervention is fully determined by the market rate for non-participating borrowers, and that simple programs of debt guarantee are optimal, while equity injections or asset purchases are not. Finally, the government does not benefit from shutting down private markets.
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