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Relationship finance, market finance and endogenous business cycles

Deidda, Luca Gabriele and Fattouh, Bassam (2010) Relationship finance, market finance and endogenous business cycles. Cagliari, CRENoS-CUEC. p. 59 (Working Papers CRENoS, 2010, 8). ISBN 978-88-84-67-579-8. Working Paper.

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Abstract

This paper develops an overlapping generation model with asymmetric information in the credit market such that the interplay between relationship finance supplied by investors who monitor investment decisions ex-ante and market finance supplied by investors who relay on public information can be the source of endogenous business fluctuations. Monitoring helps reducing the inefficiency caused by moral hazard. However, the incentives of entrepreneurs to demand relationship finance to induce monitoring –which is also non-contractible – are weaker the lower is the return to investment. If the return to investment is low enough, entrepreneurs demand too little relationship finance. This leads to an inefficiently low level of monitoring and of entrepreneurial effort. Under decreasing marginal returns to capital, the model generates a reversion mechanism that can induce macroeconomic instability. The economy can experience endogenous business cycles characterized by a pro-cyclical behavior of the relative importance of relationship finance. This is consistent with the pro-cyclical behavior of the indicator of relative importance of relationship finance, which we construct based on quarterly and annual data from the US Flow of Funds Accounts for the non-financial corporate business sector.

Item Type:Working Paper
ID Code:5634
Status:Published
Uncontrolled Keywords:Moral hazard, endogenous business cycles, relationship finance, market finance, monitoring
Subjects:Area 13 - Scienze economiche e statistiche > SECS-P/01 Economia politica
Divisions:002 Altri enti e centri di ricerca del Nord Sardegna > CRENoS-Centro Ricerche Economiche Nord Sud, Università di Cagliari e Università di Sassari
001 Università di Sassari > 01 Dipartimenti > Economia, impresa, regolamentazione
Publisher:CRENoS-CUEC
Copyright Holders:© CUEC 2010
ISBN:978-88-84-67-579-8
Publisher Policy:Depositato per gentile concessione del CRENoS e di CUEC
Deposited On:23 Feb 2011 09:25

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