Lemon Cycles

35 Pages Posted: 10 Jul 2023

See all articles by Feng Dong

Feng Dong

Tsinghua University - Tsinghua University School of Economics and Management

Ernest Liu

Princeton University

Date Written: June 29, 2023

Abstract

We build a model of endogenous credit cycles arising from the dynamics of adverse selection. Heterogeneous entrepreneurs trade productive assets in an anonymous market subject to financial frictions. Cream-skimming rent-seekers create lemon assets that can be traded. Lemon assets are indistinguishable ex-ante from the productive assets but have no productive value ex-post. The average quality of assets is the key state variable of the economy. High asset prices today attract the creation of more lemons, thereby exacerbating adverse selection and depressing the future reallocation of productive assets and asset prices. Productive and lemon assets therefore exhibit predator-prey dynamics, and the quality of assets evolves endogenously over time. The equilibrium may feature endogenous cycles and chaos, with the credit market freezing and thawing recurrently and with deterministic ups and downs in asset prices and the volume of trades. We show that a social planner has incentives to tax credit market activities in order to reduce lemon assets and to eliminate endogenous cycles.

Keywords: dynamic adverse selection, endogenous cycles, credit expansion, systemic risk, predator-prey dynamics.

JEL Classification: D82, E32, E44, G01

Suggested Citation

Dong, Feng and Liu, Ernest, Lemon Cycles (June 29, 2023). Available at SSRN: https://ssrn.com/abstract=4495056 or http://dx.doi.org/10.2139/ssrn.4495056

Feng Dong (Contact Author)

Tsinghua University - Tsinghua University School of Economics and Management ( email )

Room 623, Lihua Building, School of Economics and
Beijing, Beijing 100084
China

Ernest Liu

Princeton University ( email )

Joseph Henry House
Princeton, NJ 08542
United States

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