A dynamic theory of bank lending, firm entry, and investment fluctuations

This paper models a two-way dynamic feedback mechanism between bank lending standards and firm entry. The composition of the borrower pool affects banks' screening decisions and the credit terms they offer. Likewise, lending standards affect potential entrepreneurs' decisions to start new firms, varying the borrower pool. Firms delay borrowing when they wait for banks to finish screening or when they expect the borrower pool to improve soon. The model's predictions are consistent with basic facts on bank lending and firm entry. Moreover, the model explains why recoveries are particularly slow when preceded by large and long-term booms.