In the last decade we have witnessed episodes of successful and unsuccessful speculative attacks on domestic currencies, especially in emerging economies. Interestingly, in some of these episodes we observed that these economies entered long recessions even when the attacks were unsuccessful and confidence was recovered swiftly. The aftermath of these episodes was generally characterized by financial distress, particularly for small firms (most of which are dependenton banks for financing investments).
In this work I attempt to rationalize how an unexpected and uncorrelated shock to interest rates is capable of generating along lasting recession through an endogenous transmission mechanism. At the same time, I try to explain why small firms experience financial distress even after the cost of capital for the economy returns to normal levels.
The most important feature of the environment studied here is the existence of an asymmetric information problem between entrepreneurs and banks about the en trepreneur's managerial talent. These talents determine the firms chances of failing versus staying in business from one period to the next. While each entrepreneur knows his own talent, banks are unable to observe it.
Thus adverse selection within each cohort arises as a consequence of the informational asymmetry in credit markets. This is inefficient since highly productive entrepreneurs pay the same cost of external finance as entrepreneurs with lower productivity. Moreover, the adverse selection problem is repeated in nature because entrepreneurs keep the same talent overtime and it takes time to build financial reputation.
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Information Capital, Firm Dynamics and Macroeconomic Performance
