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Working Paper

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

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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.
Topics
Econometrics modeling and forecasting
01.27.2012ISSN 2573-7953 WP 12-04DOI 10.26509/frbc-wp-201204
Keywords agency costs, cge models, optimal contracting
JEL Classification Codes C68, E44, E61

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Carlstrom, Charles T., Timothy S. Fuerst, and Matthius Paustian. 2012. “Privately Optimal Contracts and Suboptimal Outcomes in a Model of Agency Costs.” Federal Reserve Bank of Cleveland, Working Paper No. 12-04. https://doi.org/10.26509/frbc-wp-201204