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

33 Pages Posted: 31 Jan 2012

See all articles by Charles T. Carlstrom

Charles T. Carlstrom

Federal Reserve Bank of Cleveland

Timothy S. Fuerst

University of Notre Dame

Matthias Paustian

Bank of England

Multiple version iconThere are 2 versions of this paper

Date Written: January 27, 2012

Abstract

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.

Keywords: Agency costs, CGE models, optimal contracting

JEL Classification: C68, E44, E61

Suggested Citation

Carlstrom, Charles T. and Fuerst, Timothy S. and Paustian, Matthias, Privately Optimal Contracts and Suboptimal Outcomes in a Model of Agency Costs (January 27, 2012). FRB of Cleveland Working Paper No. 12-04, Available at SSRN: https://ssrn.com/abstract=1995589

Charles T. Carlstrom (Contact Author)

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101-1387
United States
216-579-2294 (Phone)
216-579-3050 (Fax)

Timothy S. Fuerst

University of Notre Dame ( email )

Notre Dame, IN 46556
United States

Matthias Paustian

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom