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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’s outcome) is significant. A menu of time-varying taxes and subsidies on household income and monitoring costs can decentralize the planner’s allocations. But just one wedge, a time-varying tax on monitoring costs, can come close to achieving the planner’s allocation. This can also be decentralized with a time-varying subsidy on loan repayment rates.

Key words: Agency costs, CGE models, optimal contracting.
JEL codes: C68, E44, E61.

This paper is a significantly revised version of an earlier working paper of the same title (working paper no. 12-04).

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. 12-39.

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