Equilibrium Lending Mechanism and Aggregate Activity

This paper develops a model of the credit market where the equilibrium lending mechanism, as well as the economy's aggregate investment and output, are endogenously determined. It predicts that the optimal contract is one of two kinds: either with intensive monitoring by investors to overcome entrepreneurs' incentive problems, such as most of intermediated nancing, or with heavy reliance on entrepreneurs, such as market nancing. We show that the observation that bank lending falls relative to corporate bond issuance during recessions can be explained by movements in the economy's real factors, such as a decline in average investment returns, a contraction of credit supply, and paradoxically, maybe even an increase of investment demand (which worsens credit market condition and intensi es incentive problems).