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Privately Optimal Contracts and Suboptimal Outcomes in a Model of Agency Costs


This paper derives the privately optimal lending contract in the celebrated financial accelerator model of Bernanke, Gertler, and Gilchrist (1999). The privately optimal contract includes indexation to the aggregate return on capital and household consumption. Although privately optimal, this contract is not welfare maximizing as it exacerbates fluctuations in real activity. The household’s desire to hedge business cycle risk, leads, via the financial contract, to greater business cycle risk. The welfare cost of the privately optimal contract (when compared to the planner outcome) is quite large. A countercyclical tax on lender profits comes close to achieving the planner outcome.

Key words: Agency costs, CGE models, optimal contracting.

JEL codes: C68, E44, E61.


Suggested citation: Carlstrom, Charles T., Timothy S. Fuerst, and Matthias Paustian, 2012. “Privately Optimal Contracts and Suboptimal Outcomes in a Model of Agency Costs,” Federal Reserve Bank of Cleveland, Working Paper no. 12-04.

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