Privately optimal contracts and suboptimal outcomes in a model of agency costs

Carlstrom, Charles T.; Fuerst, Timothy S.; Paustian, Matthias

doi:10.26509/frbc-wp-201204

Working Paper

Privately optimal contracts and suboptimal outcomes in a model of agency costs

Abstract: This paper derives the privately optimal lending contract in the celebrated fi nancial 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 fi nancial 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 profi ts comes close to achieving the planner outcome

Keywords: Contracts; Financial markets;

https://doi.org/10.26509/frbc-wp-201204