Firm Heterogeneity and Adverse Selection in External Finance: Micro Evidence and Macro Implications

We study the macroeconomic consequences of asymmetric information between firms and external investors. To do so, we develop a heterogeneous firm macro model in which firms have private information about their quality. Private information creates a lemons problem in the market for external finance, depressing investment relative to the full information benchmark. We measure the distribution of private information, and therefore the magnitude of this lemons problem, using high-frequency stock price changes when firms raise new funding (revealing their quality to the market). We find that changes in distribution of private information are a quantitatively important determinant of aggregate fluctuations. For example, a spike in private information accounts for 40% of the decline in aggregate investment during the 2007-2009 financial crisis and made monetary stimulus significantly less effective at that time.