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Lemons Shocks and Credit Spreads

This paper develops and estimates a monetary DSGE model with adverse selection in credit markets. The model features a new shock, referred as a lemons shock, which changes the riskiness of debtors in the mean-preserving spread sense with each debtor's riskiness unknown to a creditor. The Bayesian estimation using U.S. data reveals two contrasting results. First, even though a lemons shock affects the degree of adverse selection and thus captures financial disruptions, the shock has little effect on fluctuations at standard business cycle frequencies. In contrast, the shock contributes dominantly to the Great Recession of 2007-2009 by matching a spike in credit spread. The results suggest that the Great Recession differs fundamentally from standard recessions in its causes.