Collateral Constraints and State-Contingent Contracts

Abstract

It is commonly assumed that binding collateral constraints amplify the impact of aggregate shocks on the economy. However, we show that when firms can hedge against aggregate risk with state-contingent lending contracts, binding collateral constraints no longer amplify shocks relative to the basic New Keynesian model. We embed state-contingent lending contracts in a quantitative business cycle model in the spirit of Kiyotaki and Moore (1997) and Iacoviello (2005) and find that in general equilibrium unconstrained lenders sell insurance against aggregate risk to constrained borrowers. The provision of insurance against aggregate risk prevents the usual tightening of collateral constraints during downturns and leads to relatively mild recessions.

Keywords: Collateral constraints; financial accelerator; financial frictions; optimal contract

JEL Classification: C68, E44, E61