Endogenous Financial Structure Cycles
31 Pages Posted: 12 Mar 2007
Date Written: February 2007
We study a competitive economy where entrepreneurs seek financing to produce capital goods that serve as inputs for final good production. Due to informational imperfections, choice of investment project and monitoring activity by financial investors are both non-contractible. Such non-contractibility issues increase the cost of informed finance supplied by monitoring investors relatively to the cost of uninformed finance provided by market investors, who base their investment decisions only on public information. These extra costs are a potential source of inefficiencies and multiplicity of equilibria. The efficient level of monitoring emerges as the unique equilibrium only when the marginal product of capital is sufficiently high. At relatively lower values of marginal return to capital, multiplicity of equilibria arise and, for sufficiently low values, the unique equilibrium is characterized by an inefficiently low level of monitoring. Inefficiently low levels of monitoring lead to a loss in terms of aggregate product. Accordingly, when the economy displays decreasing marginal returns to capital accumulation, the non-contractibility of monitoring services could be the source of endogenous cyclical fluctuations. Such fluctuactions are associated with countercyclical shifts toward financial structures that priviledge uninformed finance relatively to informed finance. We document the existence of cyclical movements in the composition of external finance of US firms that go in the direction highlighted by the model.
Keywords: Moral hazard, Endogenous cycles, Informed finance, Uniformed finance, Monitoring
JEL Classification: E32, E44, D82, G32
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