Asset Quality Cycles
48 Pages Posted: 1 Oct 2016 Last revised: 13 Mar 2018
Date Written: December 1, 2017
Systemic risk builds up during booms in an economy featuring asymmetric information in asset markets, where investors' hidden effort choices endogenously determine asset quality distribution. Higher asset prices during booms induce more investors to sell their assets, which lowers their incentive to improve quality. This quality deterioration in turn makes the economy vulnerable to future exogenous shocks because market breakdowns become more likely. Private agents do not internalize that their effort choices worsen future adverse selection problems, and thus the planner may improve welfare by taxing trade and thereby lowering asset prices.
Keywords: Macroeconomics, Business Cycle, Adverse Selection, Moral Hazard, Endogenous Quality
JEL Classification: D82, E32, E44
Suggested Citation: Suggested Citation