Endogenous Risk, Incentives and Aggregate Fluctuations
AbstractThis paper analyzes a model in which incentive constrained contracting implies both amplification and intertemporal propagation of technology shocks. In the model risk averse agents choose between a riskless technology and a risky technology (`the entrepreneurial activity') with higher expected return but also with moral hazard. Under the optimal contract, entrepreneurs need to bear more risk when productivity is low. This renders agents' technology choices procyclical, i.e., more agents become entrepreneurs when productivity is high, which in turn amplifies technology shocks. The technology choices and hence the amount of entrepreneurial activity can be correlated across time even if technology shocks are independent. The propagation is asymmetric and results in long expansions and short, `sharp' recessions. We think that our model complements the existing literature on the effects of countercyclical agency costs by pointing out an additional mechanism that renders agency costs countercyclical. In our model it is the risk associated with the entrepreneurial activity rather than constraints on outside funding (due to the limited resources of the entrepreneur) that constrains the amount of entrepreneurial activity. In contrast to the literature on the effects of financial contracts on aggregate dynamics which typically considers one period financial contracts only, we study (in work to be completed) both one period and multiperiod (two period) contracts and show that multiperiod contracts have important effects on the dynamic properties of aggregates. Thus, restricting attention to one period contracts importantly alters the implications for aggregate dynamics. We provide a characterization of optimal two period contracts and find that: (i) entrepreneurs who are unsuccessful early on are most likely to be credit constrained and (ii) incentive constraints are more stringent in the second period of a contract and thus compensation is optimally delayed towards that period (which may be interpreted as the accumulation of `internal funds').
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1662.
Date of creation: 01 Aug 2000
Date of revision:
Contact details of provider:
Phone: 1 212 998 3820
Fax: 1 212 995 4487
Web page: http://www.econometricsociety.org/pastmeetings.asp
More information through EDIRC
You can help add them by filling out this form.
reading list or among the top items on IDEAS.Access and download statisticsgeneral information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.