Modern Financial Systems: Theory and Applications

CHAPTER 21

Financial Activity and Capital Formation

This chapter studies relations between credit conditions, financial structure, and real economic activity. The models presented later show that credit conditions, firms’ financial conditions, and capital formation are all interdependent. While the models are informative, they are also elementary and explain only some of the links between finance and economic activity. However, as the chapter’s last section shows, model development is currently an active research area and the links will come to be better understood as the research proceeds. In evidence, the chapter summarizes recent empirical work that supplements the insights developed from the models.

ADVERSE SELECTION AND CREDIT CONDITIONS

Adverse selection can contribute to financial system fragility through its effect on credit conditions. For example, if market interest rates on deposits increase, banks must earn greater returns on their loans to compensate. The attempt to increase loan returns can mean that credit terms become more stringent. A change in terms can alter the riskiness of a pool of borrowers, leading in turn to the possibility of a credit market collapse (Mankiw 1986).

To model the situation, suppose there are many risk-neutral borrowers, each of whom seeks one unit of money to finance a project that cannot be implemented without financing. Assume the project returns X, and that the realizations of X are either x/ p with probability p or zero with probability ...