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Debt Contracts with Short-Term Commitment

  • Natalia Kovrijnykh

    (University of Chicago)

This paper analyzes the role of short-term commitment by the lender in a dynamic relationship where the borrower cannot be legally forced to make repayments. I show that short-term commitment can decrease social welfare compared to both the full and no-commitment cases considered by most of the literature. I show that the size of investment is positively related to the borrower's income. In addition, both underinvestment and overinvestment can occur in equilibrium. I also introduce the borrower's outside option and do comparative statics with respect to it. I show that the social welfare is non-monotonic in the borrower's outside option. If the borrower's outside option is interpreted as a measure of competitiveness of the credit market, this implies that an increase in the strength of competition has an ambiguous effect on welfare. Furthermore, numerical results suggest that as the outside option of the borrower increases, the renegotiation-proof equilibria converge to the Markov equilibrium, where the agents' strategies depend only on the borrower's liquidity. That is, the welfare gain from using complicated history-dependent strategies instead of simple Markov strategies is small when the borrower's outside option is high.

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Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 558.

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Date of creation: 2008
Date of revision:
Handle: RePEc:red:sed008:558
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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  1. Schnitzer, Monika, 1998. "Expropriation and Control Rights: A Dynamic Model of Foreign Direct Investment," CEPR Discussion Papers 1891, C.E.P.R. Discussion Papers.
  2. Eckhard Janeba, 2002. "Attracting Fdi in a Politically Risky World," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 43(4), pages 1127-1155, November.
  3. Thomas, J.P. & Worrall, T., 1991. "Foreign direct investment and the risk of expropriation," Discussion Paper 1991-26, Tilburg University, Center for Economic Research.
  4. Caroline Fohlin, 1998. "Relationship Banking, Liquidity, and Investment in the German Industrialization," Journal of Finance, American Finance Association, vol. 53(5), pages 1737-1758, October.
  5. Opp, Marcus M., 2012. "Expropriation risk and technology," Journal of Financial Economics, Elsevier, vol. 103(1), pages 113-129.
  6. Boot, Arnoud W. A., 2000. "Relationship Banking: What Do We Know?," Journal of Financial Intermediation, Elsevier, vol. 9(1), pages 7-25, January.
  7. Rui Albuquerque & Hugo Hopenhayn, 2002. "Optimal Lending Contracts and Firm Dynamics," RCER Working Papers 493, University of Rochester - Center for Economic Research (RCER).
  8. Ray Debraj, 1994. "Internally Renegotiation-Proof Equilibrium Sets: Limit Behavior with Low Discounting," Games and Economic Behavior, Elsevier, vol. 6(1), pages 162-177, January.
  9. Andrew Atkeson, 2010. "International lending with moral hazard and risk of repudiation," Levine's Working Paper Archive 200, David K. Levine.
  10. Doyle, Christopher & van Wijnbergen, Sweder, 1984. "Taxation of Foreign Multinationals: A Sequential Bargaining Approach to Tax Holidays," CEPR Discussion Papers 25, C.E.P.R. Discussion Papers.
  11. Natalia Kovrijnykh & Balázs Szentes, 2007. "Equilibrium Default Cycles," Journal of Political Economy, University of Chicago Press, vol. 115, pages 403-446.
  12. Quadrini, Vincenzo, 2004. "Investment and liquidation in renegotiation-proof contracts with moral hazard," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 713-751, May.
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