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Licensed Unlicensed Requires Authentication Published by De Gruyter January 1, 2010

Dysfunctional Finance: Positive Shocks and Negative Outcomes

  • Karla Hoff

In financial markets with asymmetric information about mean returns, borrowers with different default risks may pay the same rate of interest. If they do, the marginal borrower will have a high-risk, negative-value project. Under some conditions, technological change that increases each entrepreneur’s output will attract a new set of negative-value projects. This adverse selection process will erode the ability rents of the inframarginal borrowers. I present an example in which it destroys the market. The results imply that a boom in a sector can lead to a crisis if institutional change to solve the screening problem does not occur.

Published Online: 2010-1-1

©2011 Walter de Gruyter GmbH & Co. KG, Berlin/Boston

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