Agency costs, collateral, and business fluctuations
Bad economic times are typically associated with a high incidence of financial distress, e.g., insolvency and bankruptcy. This paper studies the role of changes in borrower solvency in the initiation and propagation of the business cycle. We first develop a model of the process of financing real investment projects under asymmetric information, extending work by Robert Townsend. A major conclusion here is that when the entrepreneurs who borrow to finance projects are more solvent (have more "collateral"), the deadweight agency costs of investment finance are lower. This model of investment finance is then embedded in a dynamic macroeconomic setting. We show that, first, since reductions in collateral in bad times increase the agency costs of borrowing, which in turn depress the demand for investment, the presence of these financial factors will tend to amplify swings in real output. Second, we find that autonomous factors which affect the collateral of borrowers (as in a "debt-deflation") can actually initiate cycles in output.
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Volume (Year): (1986)
Issue (Month): ()
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- Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
- Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
- Hamilton, James D., 1987. "Monetary factors in the great depression," Journal of Monetary Economics, Elsevier, vol. 19(2), pages 145-169, March.
- Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
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