This paper examines the allocation of credit in a market in which borrowers have greater information concerning their own riskiness than do lenders. It illustrates that (1) the allocation of credit is inefficient and at times can be improved by government intervention, and (2) small changes in the exogenous risk-free interest rate can cause large (discontinuous) changes in the allocation of credit and the efficiency of the market equilibrium. These conclusions suggests a role for government as the lender of last resort.

Journal Article Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly Get access N. Gregory Mankiw N. Gregory Mankiw Massachusetts Institute of Technology Search for other works by this author on: Oxford Academic Google Scholar The Quarterly Journal of Economics, Volume 100, Issue 2, May 1985, Pages 529–538, https://doi.org/10.2307/1885395 Published: 01 May 1985

According to the conventional view of the business cycle, fluctuations in output represent temporary deviations from trend. The purpose of this paper is to question this conventional view. If fluctuations in output are dominated by temporary deviations from the natural rate of output, then an unexpected change in output today should not substantially change one's forecast of output in, say, five or ten years. Our examination of quarterly postwar United States data leads us to be skeptical about this implication. The data suggest that an unexpected change in real GNP of 1 percent should change one's forecast by over 1 percent over a long horizon.

We reexamine the expectations theory of the term structure using data at the short end of the maturity spectrum. We find that prior to the founding of the Federal Reserve System in 1915, the spread between long rates and short rates has substantial predictive power for the path of interest rates; after 1915, however, the spread contains much less predictive power. We then show that the short rate is approximately a random walk after the founding of the Fed but not before. This latter fact, coupled with even slight variation in the term premium, can explain the observed change in 1915 in the performance of the expectations theory. We suggest that the random walk character of the short rate may be attributable to the Federal Reserve's commitment to stabilizing interest rates.

Modern neoclassical business cycle theories posit that the observed fluctuations in consumption and employment correspond to decisions of an optimizing representative individual. We estimate three first-order conditions that represent three tradeoffs faced by such an optimizing individual. He can trade off present for future consumption, present for future leisure, and present consumption for present leisure. The aggregate U. S. data lend no support to this model. The overidentifying restrictions are rejected, and the estimated utility function is often convex. Even when it is concave, the estimates imply that either consumption or leisure is an inferior good.