Financial Fragility and Economic Performance
Applied macroeconomists (e.g., Eckstein and Sinai (1986)) have stressed the role of financial variables, such as firm balance sheet positions, in the determination of investment spending and output. Our paper presents a formal analysis of this link. We develop a model of the process of investment finance in which there is asymmetric information between borrowers and lenders about the quality of investment projects and about the borrower's effort. In this model, the cost of external investment finance under the optimal contract is higher, the worse the borrower's balance sheet position (i.e., the lower his net worth). In general equilibrium, the lower is borrower net worth, the further the number of projects initiated and the average quality of undertaken projects will be from the unconstrained first-best. We characterize a "financially fragile" situation as one in which balance sheets are so weak that the economy experiences substantial underinvestment, misallocation of investment resources, and possibly even a complete investment collapse. Our policy analysis suggests that, under some circumstances, government "bailouts" of insolvent debtors may be a reasonable alternative in periods of extreme financial fragility.
|Date of creation:||Jul 1987|
|Date of revision:|
|Publication status:||published as Quarterly Journal of Economics, Vol. 105, No. 1, pp. 87-114, February 1990.|
|Contact details of provider:|| Postal: |
Web page: http://www.nber.org
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Smith, Bruce, 1983. "Limited Information, Credit Rationing, and Optimal Government Lending Policy," American Economic Review, American Economic Association, vol. 73(3), pages 305-18, June.
- Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
- Bernanke, Ben S, 1983.
"Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression,"
American Economic Review,
American Economic Association, vol. 73(3), pages 257-76, June.
- Ben S. Bernanke, 1983. "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression," NBER Working Papers 1054, National Bureau of Economic Research, Inc.
- Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
- Farmer, Roger E A, 1984. "A New Theory of Aggregate Supply," American Economic Review, American Economic Association, vol. 74(5), pages 920-30, December.
- John H. Boyd & Edward C. Prescott, 1985.
87, Federal Reserve Bank of Minneapolis.
- Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
- Prescott, Edward C & Townsend, Robert M, 1984.
"Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard,"
Econometric Society, vol. 52(1), pages 21-45, January.
- Edward C Prescott & Robert M Townsend, 2010. "Pareto Optima and Competitive Equilibria With Adverse Selection and Moral Hazard," Levine's Working Paper Archive 2069, David K. Levine.
- Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
- Mishkin, Frederic S., 1978. "The Household Balance Sheet and the Great Depression," The Journal of Economic History, Cambridge University Press, vol. 38(04), pages 918-937, December.
- Otto Eckstein & Allen Sinai, 1986. "The Mechanisms of the Business Cycle in the Postwar Era," NBER Chapters, in: The American Business Cycle: Continuity and Change, pages 39-122 National Bureau of Economic Research, Inc.
- Mankiw, N Gregory, 1986.
"The Allocation of Credit and Financial Collapse,"
The Quarterly Journal of Economics,
MIT Press, vol. 101(3), pages 455-70, August.
- Williamson, Stephen D, 1987. "Financial Intermediation, Business Failures, and Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 95(6), pages 1196-1216, December.
- Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
- Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:2318. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.