Aggregate Fluctuations with Adverse Selection in Credit Markets

We describe a novel channel through which credit frictions driven by adverse selection problems cause financial shocks to lead to fluctuations in real activity. When firms have private information about their default risk, firms with high probability of default have stronger incentives to run up debt while firms with low probability of default have stronger incentives to internally finance their investments. This asymmetric behavior leads to an adverse selection problem in credit markets. With adverse selection, we show that an otherwise neutral shock to dispersion of firm riskiness can lead to large changes in aggregate productivity, cross sectional dispersion of firm productivity, and credit spreads that are qualitatively in accordance with the data. We then show that a calibrated version of the model performs well regarding real and financial moments in the data.