Dynamic Adverse Selection and Belief Update in Credit Markets
65 Pages Posted: 25 Mar 2020 Last revised: 27 Aug 2021
Date Written: February 28, 2020
We develop a dynamic model of debt contracts with adverse selection. 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 lenders construct beliefs about entrepreneurial productivity based on the entrepreneur's business operation history, common productivity history, and the 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 productivity shock, cyclical asymmetry of the business cycle, slow recovery after a crisis, and constructive and destructive economic downturns.
Keywords: Adverse selection, Bayesian learning, Debt contracts, Belief update
JEL Classification: C78, D82, D86, E44, G23
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