Adverse Selection and Self-fulfilling Business Cycles∗

We develop a macroeconomic model with adverse selection. A continuum of households purchase goods from a continuum of anonymous producers. The quality of products can only be learned after trade. Adverse selection arises as low-quality goods deliver higher profits for producers but are less desirable for households. Higher aggregate demand induces more high-quality goods, raises average quality, and drives up household demand. We show that this demand externality can generate multiple equilibria or indeterminacy even when the steady state equilibrium is unique, making self-fulfilling expectation driven business cycles possible. Indeterminacy arising from adverse selection in credit markets is also constructed.