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Optimal debt contracts and moral hazard along the business cycle

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  • Pietro Reichlin
  • 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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    Cited by:

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    2. Martin, Alberto & Taddei, Filippo, 2013. "International capital flows and credit market imperfections: A tale of two frictions," Journal of International Economics, Elsevier, vol. 89(2), pages 441-452.
    3. Attar, Andrea & Campioni, Eloisa, 2003. "Costly state verification and debt contracts: a critical resume," Research in Economics, Elsevier, vol. 57(4), pages 315-343, December.
    4. Figueroa, Nicolás & Leukhina, Oksana, 2015. "Lending terms and aggregate productivity," Journal of Economic Dynamics and Control, Elsevier, vol. 59(C), pages 1-21.
    5. 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.
    6. Martin, Alberto, 2009. "A model of collateral, investment, and adverse selection," Journal of Economic Theory, Elsevier, vol. 144(4), pages 1572-1588, July.
    7. Nicolas Figueroa & Oksana Leukhina, 2008. "Information Asymmetries and an Endogenous Productivity Reversion Mechanism," 2008 Meeting Papers 563, Society for Economic Dynamics.
    8. Alberto Martin, 2004. "Endogenous credit cycles," Economics Working Papers 916, Department of Economics and Business, Universitat Pompeu Fabra, revised Aug 2008.
    9. Yunan Li & Cheng Wang, 2022. "Endogenous Labor Market Cycles," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 63(2), pages 849-881, May.
    10. Kikuchi, Tomoo & Stachurski, John & Vachadze, George, 2018. "Volatile capital flows and financial integration: The role of moral hazard," Journal of Economic Theory, Elsevier, vol. 176(C), pages 170-192.
    11. Taddei, Filippo, 2018. "Financial frictions, international capital flows and welfare," Working Paper Series 2167, European Central Bank.
    12. Chong Lai & Rui Li & Yonghong Wu, 2020. "Optimal compensation and investment affected by firm size and time-varying external factors," Annals of Finance, Springer, vol. 16(3), pages 407-422, September.
    13. Figueroa, Nicolás & Leukhina, Oksana, 2018. "Cash flows and credit cycles," Journal of Banking & Finance, Elsevier, vol. 87(C), pages 318-332.
    14. ATTAR, Andréa, 2003. "Financial contracting along the business cycle," LIDAM Discussion Papers CORE 2003069, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    15. Filippo Taddei, 2013. "International Capital Flows, Financial Frictions and Welfare," 2013 Meeting Papers 1160, Society for Economic Dynamics.
    16. Azariadis, Costas & Choi, Kyoung Jin, 2013. "Credit crunches as markov equilibria," Journal of Macroeconomics, Elsevier, vol. 38(PA), pages 2-11.

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    More about this item

    Keywords

    Financial intermediation; Asymmetric information; Business cycle.;
    All these keywords.

    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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