ABSTRACT
This chapter shows that equilibrium rationing may occur in the second sense when there is moral hazard in the lending process. It is concerns the precise conditions under which the competitive equilibrium credit rationing will occur. The other implication which is emphasized concerns the effectiveness of monetary policy in controlling aggregate demand. Monetary policy can be viewed as affecting the market for bank loans through shifts in the function which relates the opportunity rate to the total volume of bank lending. When the outcome of an investment project is high, the borrower realizes as profit the entire excess over the fixed amount due on the loan. The moral hazard problem arises because the terms of the loan influence the borrower's choice of project characteristics and thus indirectly affect the probability distribution of the outcome of the project.
