Informational Imperfections in the Capital Market and Macro-Economic Fluctuations
15 Pages Posted: 8 Mar 2007 Last revised: 27 Aug 2010
Date Written: April 1984
This paper describes the role that informational imperfections in capital markets are likely to play in business cycles. It then developes a simple illustrative model of the impact of adverse selection in the equity market and the way in which this may lead to large fluctuations in the effective cost of capital in response to relatively small demand shocks.The model also derives an expression for the cost of equity capital in the presence of adverse selection and provides informational explanations for several widely observed macro-economic phenomena.
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