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The Welfare Cost of Market Incompleteness: Opitmal Financial Contracts with Non-Enforceability Constraints

Author

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  • Thomas Cooley

    (University of Rochester)

  • Ramon Marimon

    (European University Institute)

  • Vincenzo Quadrini

    (Duke University and CEPR)

Abstract

In this paper we develop a general equilibrium model in which firms finance investment by signing long-term contracts with a financial intermediary. Due to enforceability problems, financial contracts are constrained optimal, that is, they maximize the surplus of the contract subject to incentive compatibility constraints. By comparing this model with an alternative model in which contracts are fully enforceable, we evaluate the quantitative importance of non-enforceability for the aggregate allocation of the economy. We find that in the steady state the welfare level in the economy with enforceable contracts is 2.6 percent larger than in the economy with non-enforceable contracts.

Suggested Citation

  • Thomas Cooley & Ramon Marimon & Vincenzo Quadrini, 2000. "The Welfare Cost of Market Incompleteness: Opitmal Financial Contracts with Non-Enforceability Constraints," Econometric Society World Congress 2000 Contributed Papers 1386, Econometric Society.
    • Handle: RePEc:ecm:wc2000:1386
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