Financial Intermediation and Asymmetric Information in a Small Open Economy

Abstract

The purpose of this thesis is to assess the effects of credit markets on economic activity in a small open economy with a floating exchange rate. The thesis comprises three distinct papers, each of which addresses some aspect of the theme "Financial intermediation and asymmetric information in a small open economy". Asymmetric information in credit markets arises because borrowers generally know more about their investment projects than lenders. Financial intermediaries can help overcome this imperfect information, leading to a more efficient allocation of resources and hence faster economic growth. Asymmetric information between borrowers (investors) and lenders (savers) affects the transmission mechanism of shocks in two ways. First, a shock to the economy can influence financial intermediaries' willingness to provide loans. This channel is referred to as the bank lending channel. The second channel is the balance sheet channel. It focuses on the potential impact of shocks on firms' financial positions and arises from agency costs. Agency costs in credit markets occur whenever lenders delegate control over resources to borrowers, leading to adverse selection, moral hazard and monitoring costs because of the inability to monitor borrowers or share in borrowers' information costlessly. This thesis analyses the effects of the bank lending and balance sheet channels in a dynamic general equilibrium model of a small open economy that is calibrated for New Zealand. The analysis shows that the effects of the bank lending channel are small. However, the impact of the balance sheet channel and agency costs is much larger. A decline in the degree of information asymmetry would lower agency costs and the cost of external financing, leading to an increase in the long-run level of steady state capital, investment and output. Moreover, asymmetric information and agency costs have important effects on the business cycle. The findings suggest that macroeconomic models that disregard information asymmetry between borrowers and lenders are an incomplete description of the economy. They also underline the importance of a well-functioning financial system to reduce information asymmetry and agency costs in credit markets.