Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts
John B. Donaldson
Columbia Business School - Finance and Economics
Pace University - Lubin School of Business
Marc P. Giannoni
Federal Reserve Bank of New York; Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER); Center for Economic Policy Research (CEPR)
December 1, 2011
FRB of New York Staff Report No. 531
We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. A generic family of compensation contracts similar to those employed in practice is studied. When compensation is convex in the firm’s own dividend (or share price), a given increase in the firm’s output generated by an additional unit of physical investment results in a more than proportional increase in the manager’s income. Incentive contracts of sufficient yet modest convexity are shown to result in an indeterminate general equilibrium, one in which business cycles are driven by self-fulfilling fluctuations in the manager’s expectations that are unrelated to the economy’s fundamentals. Arbitrarily large fluctuations in macroeconomic variables may result. We also provide a theoretical justification for the proposed family of contracts by demonstrating that they yield first-best outcomes for specific parameter choices.
Number of Pages in PDF File: 58
Keywords: executive compensation, delegation, indeterminacy and instability
JEL Classification: E32, J33
Date posted: January 3, 2012
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