Variation 1: Imperfect credit markets and asymmetric information

Abstract

It is a key feature of the base model introduced in the previous chapter that intermediation between savings and investment projects comes about in a smooth and entirely frictionless way. Yet, Azariadis/Smith (1996) show that this is not an innocuous assumption. In fact, the authors demonstrate that the mechanics of the Diamond model with outside money change dramatically, once a simple information asymmetry in the credit market is introduced that creates an adverse selection problem. However, to isolate the effects which arise from the information problem in the credit market, Azariadis/Smith (1996) retain the ‘bubbly’ view on money, i.e. they assume that money balances and financial assets are perfect substitutes with identical return rates. In this chapter, we summarize the essential features of the work of Azariadis/Smith (1996) and, in particular, we reproduce the effects that lead to a reversal of the results of the base model.