Investment Finance and the Costly State Verification Problem

Abstract

In this chapter we examine the implications of the costly state verification problem in the market for investment finance. Section 4.2 shows that, in the face of this problem, finance is optimally intermediated via banks and that the standard debt contract may be derived as the optimal contract. As in the previous chapters, it is possible that the credit market may be characterised by rationing in equilibrium; the policy implications of such an outcome are discussed. Section 4.3 shows how the costly state verification problem may be used as the basis of a macroeconomic model that offers an explanation for the persistence of business cycle shocks. Section 4.3 is something of a diversion from the more microeconomic thread of the rest of the book and may be skipped if the reader wishes, although it is useful in showing how asymmetric information may have important macroeconomic implications. Section 4.4 suggests some reading and section 4.5 presents some problems.