Signalling, Productivity and Investment

This paper studies the effect of inter-entrepreneurial productivity variation on investment under asymmetric information and signalling in the credit market. When productivity is not sufficiently dispersed, safe-type entrepreneurs face borrowing constraints and might under- or over-invest relative to the social optimum. Reversals in the order of productivities cause large fluctuations in investment and output. Better economic conditions, expansionary monetary policy and decreases in default probabilities do not always boost investment and welfare. When the model is extended to allow for endogenous occupational choice, would-be safe-type entrepreneurs might inefficiently select to become workers. In a numerical example, it is shown that (a) the interest rate elasticity of investment is considerably higher during booms than during busts, and (b) a decrease in interest rates during busts has an effect on both the intensive and extensive margin