Bhattacharya, Joydeep; Betts, Caroline

Economic Theory Vol. 12 no. 3 (October 1998): 489-517.

This paper develops a model in which two information frictions are embedded into an otherwise conventional neoclassical growth model; an adverse selection problem in the labor market and a costly state verification problem in the credit market. The former allows equilibrium unemployment to arise endogenously while the latter is responsible for equilibrium credit rationing. This structure is used to investigate a theoretical link between the level of unemployment and the extent of credit rationing (and capital formation). The presence of the labor market friction is enough to generate scope for multiple steady state equilibria. The model also generates a large class of endogenous cyclical and chaotic dynamical equilibria. Development trap phenomena may also appear.

JEL Classification: E13, E24, J60, J20

Keywords: unemployment, credit rationing, cycles, chaos