This paper provides a theory of endogenous leverage arising from information asymmetry to reconcile "price-quantity" puzzle and "transaction-benefit" puzzle of capital reallocation over business cycles. The key insight guiding our analysis is that credit constraints with exogenous leverage often cannot generate procyclical quantity dynamic in business cycles driven by non-financial shocks. Thus this paper departs from previous literature by introducing endogenous leverage arising from information asymmetry at credit market. We show that countercyclical adverse selection problem between entrepreneurs and creditors creates procyclical leverage cycles and generates procyclical price-quantity comovement of capital resale. We highlight a feedback loop mechanism between asset price an...[ Read more ]

This paper provides a theory of endogenous leverage arising from information asymmetry to reconcile "price-quantity" puzzle and "transaction-benefit" puzzle of capital reallocation over business cycles. The key insight guiding our analysis is that credit constraints with exogenous leverage often cannot generate procyclical quantity dynamic in business cycles driven by non-financial shocks. Thus this paper departs from previous literature by introducing endogenous leverage arising from information asymmetry at credit market. We show that countercyclical adverse selection problem between entrepreneurs and creditors creates procyclical leverage cycles and generates procyclical price-quantity comovement of capital resale. We highlight a feedback loop mechanism between asset price and leverage that amplifies business cycles.