Financial Intermediation, Moral Hazard and Pareto Inferior Trade

We consider a simple model of international trade under uncertainty, whereproduction takes time and is subject to uncertainty. The riskiness of production dependson the choices of the producers, not observable to the general public, and these choicesare influenced by the availability and cost of credit. If investment is financed by abond market, then a situation may arise where otherwise identical countries end upwith different levels of interest and different choices of technique, which again impliesdifferences in achieved level of welfare. Under suitable conditions on the parametersof the model, the market may not be able to supply credits to one of the countries.The introduction of financial intermediaries with the ability to control the debtorsmay change this situation in a direction which is welfare improving (in a suitable sense)by increasing expected output in the country with high interest rates, while opening upfor new problems of asymmetric information with respect to the monitoring activity ofthe banks.Keywords: Capital outflow, financial intermediaries, moral hazardJEL classification: F36, D92, E44