Date Added: Nov 2010
The financial crisis of 2007-08 has underscored the importance of adverse selection in financial markets. This friction has been mostly neglected by macroeconomic models of financial frictions, however, which have focused almost exclusively on the effects of limited pledgeability. In this paper, the authors fill this gap by developing a standard growth model with adverse selection. The main results are that, by fostering unproductive investment, adverse selection: leads to an increase in the economy's equilibrium interest rate, and; it generates a negative wedge between the marginal return to investment and the equilibrium interest rate. Under financial integration, they show how this translates into excessive capital inflows and endogenous cycles.