Does credit rationing imply insufficient lending?

By combining hidden types and hidden action, this paper shows that the existence of credit rationing need not imply that lending exceeds the full-information level. In this plausible class of models, the appropriate policy is not to subsidise or tax lending but to make alternatives to entrepreneurship more attractive. Doing so may actually increase the number of those borrowing to set up their own business and yield a strict Pareto improvement. The results extend to equilibria characterised by redlining. So, if interest rates fail to clear credit markets, it does not follow that policy should make loans easier to obtain. (C) 2000 Elsevier Science S.A. All rights reserved.