Asymmetric information in financial markets and economic implications

ABSTRACT Asymmetric information, by providing uncertainty in the financial markets, effects the aggregate demand adversely through the total expenditure items. Adverse selection and moral hazard are the main problems created by asymmetric information in the financial markets. At this study, firstly, these problems are reviewed conceptually. Then, their allocative effects on the financial markets and macroeconomic effects on the economy are analyzed by surveying the theoretical literature. Asymmetric information effects the economy at two different levels. At the micro level, it causes credit rationing and equity rationing. For a given interest rate at which creditors' loanable fund supply is smaller than potential borrowers' fund demand, if creditors prefer limiting credit quantity instead of increasing interest rate credit, then rationing occurs. The firms facing with credit ratoning in the process of financing investment projects could finance projects by issuing securities which increase their equity capitals. However, asymmetric information problems also show its effects in the security markets and restrict the firms' ability to find finance by issuing shares in these markets. At the macro level, asymmetric information strengthens and propagates the effects of monetary policy on the economy and provides a new monetary transmission mechanism. The channel of monetary transmission mechanism that is related to asymmetric information is called credit channel. The credit channel operates through two different mechanisms; namely bank lending and balance sheet channels. Monetary policy affects expenditure items, as being mostly the investment component, thereby aggregate demand through these new channels as well as old channels. Especially, the balance sheet channel by propogating the impacts of economic shocks plays determining role in the business cycles.