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Working Paper

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, household consumption, and the return to internal funds. Although privately optimal, this contract is not welfare maximizing as it leads to a sub-optimally high price of capital. The welfare cost of the privately optimal contract (when compared to the planner outcome) is significant. A menu of time-varying taxes and subsidies 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.

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 Matthius Paustian. 2012. “Privately Optimal Contracts and Suboptimal Outcomes in a Model of Agency Costs.” Federal Reserve Bank of Cleveland, Working Paper No. 12-39.