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Financial Intermediary Balance Sheet Management

Author

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  • John B. Donaldson
  • Natalia Gershun
  • Marc Giannoni

Abstract

We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. A generic family of compensation contracts similar to those employed in practice is studied. When compensation is convex in the firm?s own dividend (or share price), a given increase in the firm?s output generated by an additional unit of physical investment results in a more than proportional increase in the manager?s income. Incentive contracts of sufficient yet modest convexity are shown to result in an indeterminate general equilibrium, one in which business cycles are driven by self-fulfilling fluctuations in the manager?s expectations that are unrelated to the economy?s fundamentals. Arbitrarily large fluctuations in macroeconomic variables may result. We also provide a theoretical justification for the proposed family of contracts by demonstrating that they yield first-best outcomes for specific parameter choices.

Suggested Citation

  • John B. Donaldson & Natalia Gershun & Marc Giannoni, 2011. "Financial Intermediary Balance Sheet Management," Staff Reports 531, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:531
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    References listed on IDEAS

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    6. Jordi Galí & Mark J. Gertler, 2010. "International Dimensions of Monetary Policy," NBER Books, National Bureau of Economic Research, Inc, number gert07-1.
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    Keywords

    Executives; Contracts; Income;
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