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Optimal Contracts, Aggregate Risk, and the Financial Accelerator

This paper derives the optimal lending contract in the financial accelerator model of Bernanke, Gertler and Gilchrist (1999), hereafter BGG. The optimal contract includes indexation to the aggregate return on capital, household consumption, and the return to internal funds. This triple indexation results in a dampening of fluctuations in leverage and the risk premium. Hence, compared with the contract originally imposed by BGG, the privately optimal contract implies essentially no financial accelerator.

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

JEL codes: C68, E44, E61.

*A previous version of this paper was titled "Privately Optimal Contracts and Suboptimal Outcomes in a Model of Agency Costs" and posted as Federal Reserve Bank of Cleveland, working paper no. 1239R.

Suggested citation: Carlstrom, Charles T., Timothy S. Fuerst, and Matthias Paustian, 2014. “Optimal Contracts, Aggregate Risk, and the Financial Accelerator,” Federal Reserve Bank of Cleveland, Working Paper no. 14-20.

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