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Liquidity Constraints And Incentive Contracts

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  • Lehnert, Andreas
  • Ligon, Ethan
  • Townsend, Robert M.

Abstract

Are firms and households constrained in the use of a productive input? Theoretical approaches to this question range from exogenously imposed credit allocation rules to endogenous market failures stemming from some sort of limited-commitment or moral-hazard problem. However, when testing for constraints, researchers often simply ask firms or households if they would wish to borrow more at the current interest rate and/or test for suboptimal use of inputs in production functions relative to a full-information, full-commitment benchmark. We demonstrate that if credit is part of a much larger information-constrained (or limited-commitment) incentive scheme, then input use may very well be distorted away from the first-best. Further, households and firms, in certain well-defined circumstances, may, at the true interest rate or opportunity cost of credit, desire to borrow more (or less) than the assigned level of credit. In other, more constrained, contractual regimes, firms and households would say that they do not want to borrow more (or less), but these regimes are decidedly suboptimal, although the magnitude of the loss does depend on parameter values. We conclude with empirical methods that, in principle, could allow researchers armed with enough data to estimate parameters and distinguish regimes. Researchers then could see if firms and households are truly constrained and, if so, what the welfare loss might be.

Suggested Citation

  • Lehnert, Andreas & Ligon, Ethan & Townsend, Robert M., 1999. "Liquidity Constraints And Incentive Contracts," Macroeconomic Dynamics, Cambridge University Press, vol. 3(1), pages 1-47, March.
  • Handle: RePEc:cup:macdyn:v:3:y:1999:i:01:p:1-47_01
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    Cited by:

    1. Radim Bohacek, 2000. "Capital Accumulation in an Economy with Heterogeneous Agents and Moral Hazard," CERGE-EI Working Papers wp165, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    2. Mele, Antonio, 2014. "Repeated moral hazard and recursive Lagrangeans," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 69-85.
    3. Karaivanov, Alexander, 2012. "Financial constraints and occupational choice in Thai villages," Journal of Development Economics, Elsevier, vol. 97(2), pages 201-220.
    4. Philip Bond & Robert M. Townsend, 1996. "Formal and informal financing in a Chicago neighborhood," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 20(Jul), pages 3-27.
    5. Dubois, Pierre, 2002. "Consommation, partage de risque et assurance informelle : développements théoriques et tests empiriques récents," L'Actualité Economique, Société Canadienne de Science Economique, vol. 78(1), pages 115-149, Mars.
    6. Alexander Monge-Naranjo & Luis J. Hall, 2003. "Access to Credit and the Effect of Credit Constraints on Costa Rican Manufacturing Firms," Research Department Publications 3164, Inter-American Development Bank, Research Department.
    7. Prescott, Edward Simpson & Townsend, Robert M., 2002. "Collective Organizations versus Relative Performance Contracts: Inequality, Risk Sharing, and Moral Hazard," Journal of Economic Theory, Elsevier, vol. 103(2), pages 282-310, April.
    8. Alexander Karaivanov, 2003. "Financial Contracts and Occupational Choice," Computing in Economics and Finance 2003 25, Society for Computational Economics.
    9. Edward Simpson Prescott, 2005. "Technological design and moral hazard," Economic Quarterly, Federal Reserve Bank of Richmond, vol. 91(Fall), pages 43-55.
    10. Philip Bond & Paul Huck & Sherrie L. W. Rhine & Robert M. Townsend, 1999. "Small business finance in two Chicago minority neighborhoods," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 23(Q II), pages 46-62.
    11. Robert Townsend & Rolf Mueller, 1998. "Mechanism Design and Village Economies: From Credit, to Tenancy, to Cropping Groups," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(1), pages 119-172, January.
    12. Ligon, Ethan A. & Schechter, Laura, 2011. "The Value of social networks in rural Paraguay," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series qt7507w5zw, Department of Agricultural & Resource Economics, UC Berkeley.
    13. Andreas Lehnert, 1998. "Asset pooling, credit rationing, and growth," Finance and Economics Discussion Series 1998-52, Board of Governors of the Federal Reserve System (U.S.).
    14. Robert M. Townsend & Alexander Karaivanov, 2008. "Enterprise Dynamics and Finance: Distinguishing Mechanism Design from Exogenously Incomplete Markets Models," 2008 Meeting Papers 846, Society for Economic Dynamics.

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