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Optimal debt contracts and moral hazard along the business cycle

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  • Pietro Reichlin

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  • Paolo Siconolfi

Abstract

We analyze the Pareto optimal contracts between lenders and borrowers in a model with asymmetric information. The model generalizes the Rothschild-Stiglitz pure adverse selection problem by including moral hazard. 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 dynamic competitive economy and show that the average quality of the selected projects in equilibrium may be high in recessions and low in booms. This phenomenon may generate (a) multiple steady states, (b) a smaller impact of exogenous shocks on output relative to the full information case, (c) endogenous fluctuations. Copyright Springer-Verlag Berlin/Heidelberg 2004

Suggested Citation

  • Pietro Reichlin & Paolo Siconolfi, 2004. "Optimal debt contracts and moral hazard along the business cycle," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 24(1), pages 75-109, July.
  • Handle: RePEc:spr:joecth:v:24:y:2004:i:1:p:75-109 DOI: 10.1007/s00199-003-0413-0
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    References listed on IDEAS

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    1. Boyd, John H & Smith, Bruce D, 1993. "The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 427-451.
    2. Suarez, Javier & Sussman, Oren, 1997. "Endogenous Cycles in a Stiglitz-Weiss Economy," Journal of Economic Theory, Elsevier, vol. 76(1), pages 47-71, September.
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    4. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, pages 14-31.
    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. Caballero, Ricardo J & Hammour, Mohamad L, 1994. "The Cleansing Effect of Recessions," American Economic Review, American Economic Association, pages 1350-1368.
    7. Bruce C. Greenwald & Joseph E. Stiglitz, 1993. "Financial Market Imperfections and Business Cycles," The Quarterly Journal of Economics, Oxford University Press, vol. 108(1), pages 77-114.
    8. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, pages 850-855.
    9. Caballero, Ricardo J & Hammour, Mohamad L, 1994. "The Cleansing Effect of Recessions," American Economic Review, American Economic Association, pages 1350-1368.
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    Citations

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    Cited by:

    1. Martin, Alberto & Taddei, Filippo, 2013. "International capital flows and credit market imperfections: A tale of two frictions," Journal of International Economics, Elsevier, pages 441-452.
    2. 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.
    3. Martin, Alberto & Taddei, Filippo, 2013. "International capital flows and credit market imperfections: A tale of two frictions," Journal of International Economics, Elsevier, pages 441-452.
    4. ATTAR, Andréa, 2003. "Financial contracting along the business cycle," CORE Discussion Papers 2003069, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    5. Martin, Alberto, 2009. "A model of collateral, investment, and adverse selection," Journal of Economic Theory, Elsevier, vol. 144(4), pages 1572-1588, July.
    6. Filippo Taddei, 2013. "International Capital Flows, Financial Frictions and Welfare," 2013 Meeting Papers 1160, Society for Economic Dynamics.
    7. Attar, Andrea & Campioni, Eloisa, 2003. "Costly state verification and debt contracts: a critical resume," Research in Economics, Elsevier, pages 315-343.
    8. Nicolas Figueroa & Oksana Leukhina, 2008. "Information Asymmetries and an Endogenous Productivity Reversion Mechanism," 2008 Meeting Papers 563, Society for Economic Dynamics.
    9. Alberto Martin, 2004. "Endogenous credit cycles," Economics Working Papers 916, Department of Economics and Business, Universitat Pompeu Fabra, revised Aug 2008.
    10. Figueroa, Nicolás & Leukhina, Oksana, 2015. "Lending terms and aggregate productivity," Journal of Economic Dynamics and Control, Elsevier, vol. 59(C), pages 1-21.
    11. Matsuyama, Kiminori & Sushko, Iryna & Gardini, Laura, 2016. "Revisiting the model of credit cycles with Good and Bad projects," Journal of Economic Theory, Elsevier, vol. 163(C), pages 525-556.
    12. Azariadis, Costas & Choi, Kyoung Jin, 2013. "Credit crunches as markov equilibria," Journal of Macroeconomics, Elsevier, pages 2-11.

    More about this item

    Keywords

    Financial intermediation; Asymmetric information; Business cycle.;

    JEL classification:

    • A10 - General Economics and Teaching - - General Economics - - - General
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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