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Dynamic Credit Relationships in General Equilibrium

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  • Smith, A. A.
  • Wang, Cheng

Abstract

We construct a general equilibrium model with private information in which borrowers and lenders enter into long-term dynamic credit relationships. Each new generation of ex ante identical individuals is divided in equilibrium into workers and entrepreneurs. Workers save through financial intermediaries in the form of interest-bearing deposits and supply labor to entrepreneurs in a competitive labor market. Entrepreneurs borrow from financial intermediaries to finance projects which produce privately observed sequences of random returns. Each financial intermediary holds deposits from a large number of workers and operates a portfolio of dynamic contracts with different credit positions. We calibrate the model to the U.S. economy and find that dynamic contracting is very effective at mitigating the effects of private information. Moreover, restricting borrowers and lenders to use static (one-period) contracts with a costly monitoring technology has adverse effects both on the level of aggregate econonmic activity and on individual welfare unless monitoring costs are very small. Finally, the optimal provision of intertemporal incentives leads to increasing consumption inequality over time within generational cohorts as in U.S. data.

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Bibliographic Info

Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 12263.

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Date of creation: 01 May 2006
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Publication status: Published in Journal of Monetary Economics, May 2006, vol. 53 no. 4, pp. 847-877
Handle: RePEc:isu:genres:12263

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Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
Phone: +1 515.294.6741
Fax: +1 515.294.0221
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Web page: http://www.econ.iastate.edu
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References

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Citations

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Cited by:
  1. Jeremy Greenwood & Juan M. Sánchez & Cheng Wang, 2010. "Financing development: the role of information costs," Working Papers 2010-024, Federal Reserve Bank of St. Louis.
  2. Andreasen, Martin & Ferman, Marcelo & Zabczyk, Pawel, 2012. "The business cycle implications of banks’ maturity transformation," Bank of England working papers 446, Bank of England.
  3. Li, Shuyun May, 2013. "Optimal lending contracts with long run borrowing constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 37(5), pages 964-983.
  4. Jin, Yu, 2010. "Credit Termination and the Technology Bubbles," MPRA Paper 29010, University Library of Munich, Germany.
  5. Stephane Verani & Till Gross, 2012. "Financing constraints, firm dynamics, and international trade," Finance and Economics Discussion Series 2012-68, Board of Governors of the Federal Reserve System (U.S.).
  6. Wang, Cheng, 2011. "Termination of dynamic contracts in an equilibrium labor market model," Journal of Economic Theory, Elsevier, vol. 146(1), pages 74-110, January.
  7. Hachem, Kinda, 2011. "Relationship lending and the transmission of monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(6), pages 590-600.
  8. Shuyun May Li, 2009. "Optimal Lending Contracts with Asymmetric Information and Two-sided Limited Commitment or Impatient Entrepreneur," Department of Economics - Working Papers Series 1065, The University of Melbourne.

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