Equilibrium loan contracts and endogenous growth in the presence of asymmetric information

This paper considers an endogenous growth model in which an informational asymmetry exists between capital producing borrowers and lenders as to the borrower's ability to successfully operate an investment project. In contrast to previous models of this genre, the lender can induce self-selection either by rationing a fraction of borrowers, or by using a costly screening technology, or by a mix of the two. The equilibrium contract's form and the growth rate of output are mutually dependent and are jointly determined. The effect of the lower cost of screening on the growth rate of output has been considered. We show that a decline in the screening cost, paradoxically, may lower the growth rate of output. Only when a threshold level of sophistication is crossed will the benefit of an advanced financial sector become evident in a higher growth rate.