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Optimal Debt Contracts and Moral Hazard Along the Business Cycle

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  • Reichlin, Pietro
  • Siconolfi, Paolo

Abstract

We analyse the Pareto optimal contracts between lenders and borrowers in a model with asymmetric information. The model is a generalization of the Rothschild-Stiglitz pure adverse selection problem to include moral hazard with limited liability contracts. Entrepreneurs with unequal ``abilities" borrow to finance alternative investment projects which differ in degree of risk and productivity. We determine the endogenous distribution of projects as functions of the amount of loanable funds, when lenders have no information about borrowers' ability and technological choices. Then, we embed these results in a general equilibrium overlapping generations economy with production and show that, for a wide set of economies, equilibria are characterized by multiple steady states and persistent endogenous cycles such that the average quality of the selected projects is high in recessions and low in booms.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2351.

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Date of creation: Jan 2000
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Handle: RePEc:cpr:ceprdp:2351

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Keywords: Business Cycle; Financial Intermediation;

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References

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  1. Bruce C. Greenwald & Joseph E. Stiglitz, 1988. "Financial Market Imperfections and Business Cycles," NBER Working Papers 2494, National Bureau of Economic Research, Inc.
  2. Caballero, Ricardo J & Hammour, Mohamad L, 1994. "The Cleansing Effect of Recessions," American Economic Review, American Economic Association, vol. 84(5), pages 1350-68, December.
  3. Boyd, J.h. & Smith, B.D., 1991. "The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification," RCER Working Papers 289, University of Rochester - Center for Economic Research (RCER).
  4. Suarez, Javier & Sussman, Oren, 1997. "Endogenous Cycles in a Stiglitz-Weiss Economy," CEPR Discussion Papers 1604, C.E.P.R. Discussion Papers.
  5. Reichlin, Pietro & Siconolfi, Paolo, 1997. "Adverse Selection of Investment Projects and the Business Cycle," CEPR Discussion Papers 1631, C.E.P.R. Discussion Papers.
  6. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 630-49, November.
  7. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  8. Bester, Helmut, 1987. "The role of collateral in credit markets with imperfect information," European Economic Review, Elsevier, vol. 31(4), pages 887-899, June.
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Citations

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Cited by:
  1. Martin, Alberto, 2009. "A model of collateral, investment, and adverse selection," Journal of Economic Theory, Elsevier, vol. 144(4), pages 1572-1588, July.
  2. ATTAR, Andréa, 2003. "Financial contracting along the business cycle," CORE Discussion Papers 2003069, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  3. Gunnar Bardsen & Kjersti-Gro Lindquist & Dimitrios P.Tsomocos, 2006. "Evaluation of macroeconomic models for financial stability analysis," OFRC Working Papers Series 2006fe01, Oxford Financial Research Centre.
  4. Alberto Martin & Filippo Taddei, 2010. "International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions," Carlo Alberto Notebooks 160, Collegio Carlo Alberto, revised 2011.
  5. Filippo Taddei, 2013. "International Capital Flows, Financial Frictions and Welfare," 2013 Meeting Papers 1160, Society for Economic Dynamics.
  6. Alberto Martin, 2004. "Endogenous credit cycles," Economics Working Papers 916, Department of Economics and Business, Universitat Pompeu Fabra, revised Aug 2008.
  7. Azariadis, Costas & Choi, Kyoung Jin, 2013. "Credit crunches as markov equilibria," Journal of Macroeconomics, Elsevier, vol. 38(PA), pages 2-11.
  8. Nicolás Figueroa & Oksana Leukhina, 2009. "Information Asymmetries and an Endogenous Productivity Reversion Mechanism," Documentos de Trabajo 264, Centro de Economía Aplicada, Universidad de Chile.
  9. Attar, Andrea & Campioni, Eloisa, 2003. "Costly state verification and debt contracts: a critical resume," Research in Economics, Elsevier, vol. 57(4), pages 315-343, December.

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