Aggregate Consequences of Dynamic Credit Relationships

Abstract

Which financial frictions matter in the aggregate? This paper presents a general equilibrium model in which entrepreneurs finance a firm with a long-term contract. The contract is constrained efficient because firm revenue is costly to monitor and entrepreneurs may default. The cost of monitoring firms and the entrepreneurs' outside options determine the significance of moral hazard relative to limited enforcement for financial contracting. Calibrating the model to the U.S. economy, I find that the relative welfare loss from financial frictions is about 5 percent in terms of aggregate consumption with moral hazard, while it is 1 percent with limited enforcement. Reforms designed to strengthen contract enforcement increase aggregate consumption in the short-run, but their long-run effects are modest when monitoring costs are high. Weak contract enforcement contributes to aggregate fluctuations by amplifying the effect of aggregate technological shocks, but moral hazard does not.JEL Codes: E32, D82, G32, L14

Bankruptcy Choice with Endogenous Financial Constraints

“…That paper documents that renegotiations are more likely to be favorable to the borrower when she has access to relatively inexpensive alternative sources of financing. In general equilibrium without aggregate risk, the outside option could correspond to the value of searching for a new project as in Cooley et al (2004) or Verani (2014), once a stochastic penalty for breach of contract is introduced. Likewise, in an occupational choice framework, the outside option could be identified with an offer in the labor market as in Buera et al (2011) or Antunes et al (2008) with an idiosyncratic and stochastic labor ability component.…”

“…Some recent work on bankruptcy procedures and firm dynamics suggests that this mechanism can be quantitatively important (Rodriguez-Delgado (2010)). Although tractability issues may arise, the model could also be extended to study the role of bankruptcy arrangements in amplifying or ameliorating the effects of aggregate shocks as in Verani (2014), and in shaping recoveries from pronounced recessions. Circumstantial evidence can be found in Bergoeing et al (2007) suggesting that differences in bankruptcy law can help account for the asymmetric recoveries of Chile an Mexico from similar negative shocks experienced in the early 1980s.…”

“…Notice that, in constrasts with CH, Quadrini (2004) and Verani (2014), the model produces signifficant growth dispersion in the stationary distribution. This follows from the heterogeneity in project types, a feature that is absent in these papers.…”

“…6 A recent exception is Verani (2014) who also studies asymmetric information and limited commitment together in a model of firm dynamics under aggregate uncertainty.…”