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Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts

58 Pages Posted: 3 Jan 2012  

John B. Donaldson

Columbia Business School - Finance and Economics

Natalia Gershun

Pace University - Lubin School of Business

Marc P. Giannoni

Federal Reserve Banks - Federal Reserve Bank of Dallas; Center for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: December 1, 2011

Abstract

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.

Keywords: executive compensation, delegation, indeterminacy and instability

JEL Classification: E32, J33

Suggested Citation

Donaldson, John B. and Gershun, Natalia and Giannoni, Marc P., Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts (December 1, 2011). FRB of New York Staff Report No. 531. Available at SSRN: https://ssrn.com/abstract=1978905 or http://dx.doi.org/10.2139/ssrn.1978905

John B. Donaldson

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Natalia Gershun

Pace University - Lubin School of Business ( email )

1 Pace Plaza
New York, NY 10038-1502
United States
1-(212) 618-6515 (Phone)

Marc P. Giannoni (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5291 (Phone)

Center for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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