This paper develops an overlapping generation model with asymmetric information
in the credit market such that the interplay between relationship finance
supplied by investors who monitor investment decisions ex-ante and market finance
supplied by investors who relay on public information can be the source of endogenous
business fluctuations. Monitoring helps reducing the inefficiency caused by
moral hazard. However, the incentives of entrepreneurs to demand relationship finance
to induce monitoring –which is also non-contractible – are weaker the lower
is the return to investment. If the return to investment is low enough, entrepreneurs
demand too little relationship finance. This leads to an inefficiently low level of
monitoring and of entrepreneurial effort. Under decreasing marginal returns to capital,
the model generates a reversion mechanism that can induce macroeconomic
instability. The economy can experience endogenous business cycles characterized
by a pro-cyclical behavior of the relative importance of relationship finance. This is
consistent with the pro-cyclical behavior of the indicator of relative importance of
relationship finance, which we construct based on quarterly and annual data from
the US Flow of Funds Accounts for the non-financial corporate business sector.