Optimal Debt Contracts and Moral Hazard Along the Business Cycle

We analyse the Pareto optimal contracts between lenders and borrowers in a model with asymmetric information. The model is a generalization of the Rothschild-Stiglitz pure adverse selection problem to include moral hazard with limited liability contracts. Entrepreneurs with unequal ``abilities" borrow to finance alternative investment projects which differ in degree of risk and productivity. We determine the endogenous distribution of projects as functions of the amount of loanable funds, when lenders have no information about borrowers' ability and technological choices. Then, we embed these results in a general equilibrium overlapping generations economy with production and show that, for a wide set of economies, equilibria are characterized by multiple steady states and persistent endogenous cycles such that the average quality of the selected projects is high in recessions and low in booms.