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Author(s): Ben Bernanke and Mark Gertler

Source: The American Economic Review, Vol. 79, No. 1 (Mar., 1989), pp. 14-31

Published by: American Economic Association

Stable URL: http://www.jstor.org/stable/1804770

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Agency Costs, Net Worth, and Business Fluctuations

This paper developsa simple neoclassical model of the business cycle in which the

condition of borrowers' balance sheets is a source of output dynamics. The

mechanism is that higher borrowernet worthreduces the agency costs of financing

real capital investments.Business upturnsimprove net worth, lower agency costs,

and increase investment, which amplifies the upturn; vice versa, for downturns.

Shocks that affect net worth (as in a debt-deflation)can initiate fluctuations.

Many students of the business cycle have particular balance sheet variable upon which

suggested that the condition of firm and we focus is borrower net worth.' Net worth

household balance sheets (equivalently, the is important, we believe, for the following

state of borrower "solvency" or "credit- reason: Whenever there is an asymmetry of

worthiness") is an important determinant of information between borrowers and lenders,

macroeconomic activity. For example, Fred- optimal financial arrangements will typically

eric Mishkin (1978) and Ben Bernanke (1983) entail deadweight losses (agency costs), rela-

argued that the weakness of borrowers' bal- tive to the first-best perfect-information

ance sheets contributed to the severity of the equilibrium; these costs manifest themselves

Great Depression, while Otto Eckstein and as a higher cost of "external," as compared

Allen Sinai (1986) put firm balance sheet to "internal," funds. For the particular model

variables at the center of their analysis of used here, and for most standard principal-

cyclical dynamics. Numerous studies have agent models, it is true that the greater the

connected balance sheet conditions with level of net worth of the potential borrower,

household and firm spending decisions. the less will be the expected agency costs

In this paper we present a formal analysis implied by the optimal financial contract.2

of the role of borrowers' balance sheets in Thus periods of financial "distress" (when

the business cycle. Our vehicle is a modified borrower net worth is low) are also times of

"real business cycle" model, in which a char- relatively high agency costs in investment.

acteristic of the investment technology is an At the macroeconomic level, the proposi-

asymmetry of information between the en- tion that borrower net worth and the agency

trepreneurs who organize and manage physi- costs of investment are inversely correlated

cal investment and the savers from whom has at least two significant implications.

they borrow. Specifically, we assume a

"costly state verification" problem, as in

Robert Townsend (1979, 1988). This infor- IMore specifically, the focus is on "collateralizable"

mational asymmetry makes the Modigliani- net worth, as opposed to, for example, human capital.

Miller theorem inapplicable, opening up the For simplicity of modeling, we do not distinguish in this

paper among assets that are more or less easy to sell or

possibility of an interesting interaction be- borrow against. The issues raised by varying balance

tween real and "financial" (i.e., balance sheet liquidity are deserving of further research.

sheet) factors. 2This proposition is quite general. For example, in

Several aspects of balance sheets are po- his analysis of the perhaps more familiar Bengt Holm-

tentially of interest to macroeconomists: The strom, 1979, principal-agent setup, in which agents'

unobserved actions affect project returns, David Sap-

pington, 1983, demonstrated a similar inverse relation-

ship between the agent's wealth and the agency costs of

*Princeton University, Princeton, NJ 08544 and Uni- the principal-agent relationship. See Bernanke and Mark

versity of Wisconsin, Madison, WI 53706, respectively. Gertler, 1987, for another example and for references.

Numerous colleagues and several referees provided use- For a model in which this result need not hold, see

ful advice. Barry Nalebuff was especially helpful. Joseph Stiglitz and Andrew Weiss, 1987.

14

VOL. 79 NO. I BERNANKE AND GERTLER: BUSINESS FLUCTUATIONS 15

First, since borrower net worth is likely to be and agency costs. Section III, Parts A, B

procyclical (borrowers are more solvent dur- consider optimal lending contracts and the

ing good times), there will be a decline in entrepreneurial investment decision for this

agency costs in booms and a rise in reces- case. Implications for macroeconomic equi-

sions. We will show that this is sufficient to librium dynamics are investigated in Sec-

introduce investment fluctuations and cycli- tion III, Parts C, D; we show that, in con-

cal persistence into an environment which is trast to the perfect-information case, the

rigged to exhibit neither of these features economy with agency costs exhibits persis-

when agency costs are not present; a kind of tent fluctuations in investment and output,

accelerator effect emerges. Second, shocks to and that redistributions between borrowers

borrower net worth which occur indepen- and lenders (as in a debt-deflation) have real

dently of aggregate output will be an initiat- aggregate effects. Section IV concludes. Ad-

ing source of real fluctuations. A possible ditional results on the nature of the optimal

example of this is the "debt-deflation," first contract under "costly state verification" are

analyzed by Irving Fisher (1933): During a presented in the Appendix.

debt-deflation, because of an unanticipated

fall in the price level (or, alternatively, a fall I. The Model

in the relative price of borrowers' collateral,

for example, farmland), there is a decline in Our starting point is a generic "real busi-

borrower net worth. This has the effect of ness cycle model," that is, a stochastic neo-

making those individuals in the economy classical growth model. This framework

with the most direct access to investment allows us to illustrate starkly the role of

projects suddenly un-creditworthy (i.e., the financial factors, since in the standard ver-

agency costs associated with lending to-them sion of the real business cycle model (for

are high). The resulting fall in investment example, Edward Prescott, 1986), the as-

has negative effects on both aggregate de- sumption of perfect markets implies that fi-

mand and aggregate supply. We perform a nancial structure is irrelevant. Specifically,

preliminary analysis of the macro effects of a we study an overlapping generations (OG)

shock to borrower net worth using the model model, in the general form used by Peter

developed below. Diamond (1965). The OG approach has the

We have tried to conduct our analysis advantage of providing a tractable frame-

solely from first principles. In particular, we work for dynamic general equilibrium analy-

derive the form of all financial arrangements sis, into which heterogeneity among borrow-

endogenously, and we do not rule out ran- ers and lenders is easily incorporated. The

domizing strategies and lotteries. The model OG setup also allows us to abstract (for the

is thus necessarily simple, and our analysis present paper) from long-term financial rela-

should be viewed as an attempt to obtain tionships.3 The "generations" in our model

qualitative insights, rather than to provide should be thought of as representing the

an empirically realistic description of real- entry and exit of firms from credit markets,

financial interactions. Other papers in this rather than as literal generations; a "period"

area which proceed in a general manner sim- in our model should therefore be interpreted

ilar to ours include those of Roger Farmer as the length of a typical financial contract

(1984), Bruce Greenwald and Joseph Stiglitz (for example, a bank loan).

(1986), and Stephen Williamson (1987). As in Diamond (1965) we will assume that

The plan of this paper is as follows: Sec- each generation of individuals lives for two

tion I lays out the assumptions of the model. periods; and that individuals are able to earn

Section II analyzes the benchmark-perfect labor income only in the first period of life,

information case. The equilibrium in this

case is rigged to involve no business cycle

dynamics (investment is constant and output 3For equilibrium analyses of the implications of

fluctuations are serially independent). Sec- long-term relationships in agency settings, see Edward

tion III introduces asymmetric information Green, 1987, and Gertler 1988.

16 THE A MERICAN ECONOMIC RE VIE W MARCH 1989

so that they must save to finance second- we will generally have to deal in per capita,

period consumption. In Diamond's paper it rather than aggregate, quantities.)

is assumed that saving can be done either by There are two classes of agents. An exoge-

investing in physical capital or by purchas- nous fraction r7of individuals in each gener-

ing government bonds: For an expositional ation are called "entrepreneurs."The rest of

reason that will be explained, we make con- the population will be called "lenders." En-

sumption-good inventories, rather than gov- trepreneurs and lenders differ in endow-

ernment bonds, the alternative mode of sav- ments and preferences; much more impor-

ings to capital investment. Our model also tantly, they differ in that only entrepreneurs

differs from Diamond's original (which was have direct access to the investment technol-

non-stochastic) in that, in the spirit of the ogy (see below).

real business cycle literature, we allow for The class of entrepreneurs is itself not

shocks to the aggregate production function. homogeneous: We will assume that individ-

The modifications to Diamond's model ual entrepreneurs are indexed by a parame-

just described are minor and have no partic- ter co, which in the population of en-

ularly surprising implications. The signifi- trepreneurs is uniformly distributed on [0,11.

cant distinction between our model and Dia- Low-co entrepreneurs will have a lower cost

mond's is that we replace his simple capital of investment, and thus may be thought of

production technology (in which output is as more "efficient." (Again, see below.)

transformed into capital one-for-one) with a Goods. There are two goods, a capital good

technology that involves asymmetric infor- and an output good. Output produced in a

mation. Specifically, we assume that only the given period t may be consumed by agents

entrepreneurs who direct physical invest- during t, or it may be invested in the pro-

ment can costlessly observe the returns to duction of the capital good (which becomes

their individual projects; outside lenders available for use in t + 1). We also allow

must jointly incur a fixed cost to observe output to be stored directly as an inventory.

those returns. This "costly state verification" The gross rate of return on storage is r, r ? 1;

model was first analyzed by Townsend (1979, that is, a unit of output stored in t yields r

1988);4 he showed that the optimal financial units in t + 1.

arrangements in this setting will involve Capital cannot be consumed but can be

(most likely randomized) auditing strate- used in the production of output. Capital is

gies by lenders, which introduce dissipative assumed to depreciate fully in one period

agency costs into the process. A main goal of (this is expositional reasons only).

this paper is to draw a connection between Production Technologies. There are sepa-

the condition of borrower balance sheets and rate production technologies for output and

these agency costs, and to demonstrate how for capital. The output good is produced by

this connection may play a role in the busi- a constant returns technology using capital

ness cycle. and labor. We will assume below that labor

The detailed assumptions of the model are supplies are fixed;5 we may therefore write

now stated. the production function in per capita6 terms.

Time. Time is infinite in the forward direc- For any period t, the production function

tion and is divided into discrete periods in- for per capita output y, is assumed to be

dexed by t.

Agents. There are overlapping generations (1) yt = #tf ( kt),

of two-period lived agents (and an initial

"old" generation in period zero). It will be

convenient to assume that there are a count-

able infinity of agents in each generation. 5We focus here on explaining investment fluctuations

(An implication of this assumption is that rather than employment fluctuations. Extensions of the

results to the case with variable employment is straight-

forward in principle.

6Throughout "per capita" means "per member of a

4See also Douglas Gale and Martin Hellwig, 1985. given generation."

VOL. 79 NO. 1 BERNANKE AND GERTLER: BUSINESS FLUCTUATIONS 17

where kt is the amount of capital per head, the outcome of the audited project to every-

and 9, is a random aggregate productivity one in the economy and without error.7 An

shock. We assume that some production can entrepreneur who underreports the return to

take place without capital, that is, f(0) > 0. his project and is not audited can enjoy extra

We take the random variable # to be i.i.d. consumption equal to the marginal product

over time, to be distributed continuously over of his extra capital. We assume that it is not

a finite positive support, and to have a mean possible, without auditing, to infer the out-

equal to 9. come of a particular entrepreneur's project,

Output in period t can be transformed for example, it is not possible for others to

into period-(t + 1) capital (without the use of observe the entrepreneur's second-period

labor) by means of an investment technol- holdings of capital or his realized consump-

ogy. This investment technology comes in tion. We will assume that random auditing is

discrete, nondivisible units, called "projects." feasible; that is, lenders can pre-commit to

Each entrepreneur is endowed with one of auditing with some probability (which may

these projects (and we assume that it is too depend on the announced outcome). Finally,

costly to trade or transfer a project away it makes things a bit simpler to assume that

from the original owner). A project belong- project outcomes are realized, announce-

ing to an entrepreneur of type X takes as ments are made, and auditing takes place

input exactly x(w) units of the output good before the current value of 0 is known; thus,

y, where x(.) is increasing in co. With less incentive constraints relevant to decisions in

than x(w) units of y, nothing is produced, t need depend only on expected values of

and the marginal product of increments of y functions of ?t+l?

to a project that already has its requisite Investment projects undertaken in a given

quantity of input is zero. period have mutually independent outcomes,

Any project that is undertaken in t pro- so that there is no aggregate (per capita)

duces a quantity of capital, which is avail- uncertainty about the quantity of capital

able for use in t + 1. The amount of capital produced, that is, expected and actual capi-

produced by a given project is a discrete tal per head are the same. Let it be the

random variable with possible outcomes Ki, number of investment projects undertaken in

i =1,2...,n, with Kj(?Kk for j>k. (In the t per capita, and let ht be the fraction of

main text we will focus on the case n = 2.) projects initiated in t that are audited. (Both

The probability of outcome Ki is vi, and the it and ht will be endogenous in general

expected outcome is K. Note that project equilibrium.) For any period t, then, next-

outcomes do not depend on the entre- period capital stock per head, kt+1, is given

preneur's type co, although the quantity of by

inputs does (high-c entrepreneurs require

higher inputs); this is a simple way of moti- (2) kt+1 = (K- h tY)it.

vating an upward-sloping supply curve of

capital goods. The distribution of outcomes We also assume

is identical ex ante across projects and is not

affected by any action or effort of the indi- (3) Of'(O)K> rx(O) + y,

vidual entrepreneur.

To introduce issues of asymmetric infor- (4 Of (K-q) <_X(1).

realized outcome of any particular invest-

ment project is costlessly observable only by 7Alternatively, we could have assumed that auditing

the entrepreneur who operates (was endowed results are private information to the auditor. Then a

with) that project. Other agents in the econ- role would arise for zero-profit intermediaries between

omy can learn the realized returns of a given lenders and entrepreneurs. These intermediaries would

project only by employing an auditing tech- internalize all auditing costs and, by holding perfectly

diversified portfolios, could eliminate the need to be

nology. This technology absorbs y units of monitored by depositors (see Douglas Diamond, 1984,

the capital good when operated, but reveals and Stephen Williamson, 1987).

18 THE A MERICAN ECONOMIC RE VIE W MARCH 1989

(3) and (4) will be sufficient to guarantee overall per capita income of the young gen-

that it is always profitable for some but not eration is wt.) Entrepreneursdo not consume

all entrepreneurs to operate. when young, so average entrepreneurial sav-

Endowments. Every individual has a ing, Sf, is given simply by

fixed-labor endowment, which must be used

during the first period of life. The labor (6) Se = wLe

endowment of an entrepreneur is L', the

endowment of a lender is L. As a normaliza- Entrepreneurial saving will be an important

tion, we assume that the economywide per variable in the subsequent analysis.

capita labor endowment, qLLe+(1- q)L, is Lenders do consume in the first period, so

equal to one; this way we avoid carrying that their saving depends on the interest rate

around the distinction between per capita as well as the wage. We will make assump-

and per labor-input variables. tions to guarantee that saving always ex-

Preferences. Individual preferences are de- ceeds capital formation ((see (9) below), so

fined over lifetime consumption (there is no there is always storage of inventories in equi-

disutility of labor). We assume that en- librium. Thus the marginal rate of return is

trepreneurs care about only expected con- fixed at r, the rate of return to storage.

sumption when old, that is, they are risk- Maximization of (5) implies that there is an

neutral and do not consume when young. optimal consumption for lenders when

Lenders consume in both periods; lenders young, denoted z* (r). Average savings by

born in t have identical utility functions of lenders, St, is thus

the form

(7) S, = wL - z (r).

(5) U(zY)+PEt(zO 1) The main import of (6) and (7) is the

where z Y and z 1 are the consumption of establishment of a direct link between wages

the representative period-t lender when (marginal productivities) and saving. This

young and old, respectively, U(.) is of the link, not empirically unreasonable in itself, is

usual concave form, and 18 is a discount supposed to proxy for the more general idea

factor. that savings (and wealth) are greater when

The key restriction imposed by our speci- the economy is doing well.

fication of preferences is that both borrowers We turn now to characterizing the rest of

and lenders in t are risk-neutral with respect the competitive equilibrium for our model

to period-(t + 1) consumption; as in Sap- economy.

pington (1983), the assumption of risk-neu-

trality permits us to concentrate on the role II. Equilibriumwith Perfect Information

of the agent's wealth. in mitigating agency

costs, rather than on issues of risk-sharing. As a benchmark, we first consider the

The assumptions that entrepreneurs and competitive equilibrium of our model when

lenders have different utility functions and, auditing is free (y = 0), so that information

in particular, that entrepreneurs do not con- is perfect. We begin by solving for equilib-

sume when young are inessential. rium in period t, given the inherited capital

We will focus on the behavior of this stock per head, kt; we then turn to the

model economy in a competitive market en- (trivial) dynamics.

vironment. In such an environment, our Let qt+1 be the expected (as of t) relative

agents' labor supply and consumption/sav- price of capital in t +1; then qt+l is the

ing behavior are easy to describe. Labor is expected gross return from each investment

supplied inelastically, so that, if the market project. The opportunity cost of investing

wage per unit of labor endowment is wt, for a type-c entrepreneur is rx(cX). Assum-

entrepreneurs have per capita incomes of ing that entrepreneurs invest when they can

wtL' and lenders have per capita incomes of earn nonnegative profits, the efficiency level

wtL. (By our normalization assumption, X of the entrepreneur who is just indifferent

VOL. 79 NO. 1 BERNANKE AND GERTLER: BUSINESS FLUCTUATIONS 19

levels X of X or better (i.e., X ?< ) produce

D

an expected surplus, relative to storage. (Note

that X is a functionof 4t+ .)

We assume, as noted in the previous sec-

tion, that economywide savings always ex-

ceed the amount required by profitable pro-

jects kt+l

any inherited level of kt. (For this to be 1). A higher expected value of qt?I raises the

plausible, the entrepreneurial sector needs to number of entrepreneurs who can profitably

be a relatively small part of the economy.) invest, so that a larger share of savings is

Thus some saving always funds inventory devoted to capital formation instead of to

accumulation in equilibrium and the margin- consumption good inventories.

al rate of return is always r. The "capital demand curve" for the per-

The interesting issue is the joint determi- fect information case, DD, is just the condi-

nation, in period t, of +t?I and the next- tion that the expected price of capital equals

period capital stock per head, kt+1. Let it be its expected marginal product

the number of projects undertaken (per

capita) in t. Then we have (13) qt+1= f'(kt+j1 [DD],

denotes the derivative. The DD curve is

(1) kt+i= Kit,

downward-sloping (see Figure 1); the mar-

ginal product of capital is higher when the

(10) follows from the observation that any capital stock (per head) is smaller. In each

entrepreneur of efficiency level X or better period t,qt+l and kt+l are determined as

(which, since X is uniform, is a fraction X of the solution of (12) and (13), that is, as the

all entrepreneurs) will find it profitable to intersection of the capital supply and de-

invest when the cost of funds is r. Thus (10) mand curves in Figure 1.8

states that investment per capita equals the The dynamics in the perfect information

fraction of entrepreneurs who invest times case are extremely simple: Since (12) and

the fraction of the population who are en- (13) are independent of period-t state vari-

trepreneurs. (l) -says that the per capita ables, q and k are constant over time.

future capital stock will be the average pro- Investment is fixed and the quantity of pro-

ductivity of an investment project (which, by duction of the output good fluctuates in pro-

the law of large numbers, is non-stochastic) portion to the (serially uncorrelated) produc-

times the per capita number of projects. tivity shock. The amount of consumption is

Combining (8), (10), and (11) yields a positively serially correlated, since in high-

"capital supply curve" for the perfect infor- productivity periods there is both more con-

mation case (call it the SS curve): sumption and more inventory accumulation.

8The solution exists and is unique. Existence is guar-

anteed by (3) and (4), uniqueness by the fact that DD

The SS curve is upward-sloping (see Figure always slopes downward and SS always slopes upward.

20 THE A MERICAN ECONOMIC RE VIEW MARCH 1989

We have thus developed a benchmark case than r, (ii) the entrepreneurhas no incentive

in which investment is constant. This was to lie about realized project outcomes, and

the motivation for introducing inventories (iii) the state-contingent consumptions and

which pay a fixed-gross yield: The presence auditing probabilities10 are feasible. The

of this fixed-return mode of saving has control variables are outcome-dependent au-

the effect of making the supply of invest- diting probabilities and the entrepreneur's

ment funds perfectly elastic with respect to realized consumption levels, which may be

the interest rate, while investment demand contingent both on the project outcome and

(which, in the absence of information prob- on whether an audit has occurred.

lems, depends only on the expected marginal The Appendix formally states the problem

productivity of capital and the marginal cost and gives a number of results for the n-state

of producing new capital) is fixed over time. case. For the main text, we choose to special-

In contrast, when information asymmetries ize to the case n = 2. This is for the sake of

are present, investment demand will vary concreteness; for n = 2, it is possible to write

and be history-dependent. out the optimal contract explicitly, while for

a larger number of states we have only been

III. Equilibrium

withAsymmetricInformation able to obtain indirect characterizations. It is

worth stressing, however, that the n-state

A. The Optimal Financial Contract optimal contract does have the "net worth

property," that expected agency costs are

We now re-introduce imperfect informa- decreasing in the amount of entrepreneurial

tion (-y > 0) and begin the process of deriv- savings contributed to the project. Therefore,

ing the dynamic macroeconomic equilibrium we can safely claim that allowing for an

for this case. This is done in stages: We arbitrary number of possible project out-

begin by considering the situation of an en- comes in our macroeconomic analysis would

trepreneur who with certainty intends to un- not affect the qualitative nature of our re-

dertake his project,9 but for whom the re- sults.

quired project input exceeds his personal With n = 2, there are two possible project

savings (x(o) > Se). In this case, the en- outcomes: In state 1 (which occurs with

trepreneur must borrow in order to invest. probability rl), the project produces K, units

Our task is to determine the optimal ar- of the capital good; in state 2 (probability

rangements under which this borrowing can ,r2) it produces K2 units. State 1 is the "bad"

take place. state (Ki < K2). For an entrepreneur of type

The entrepreneur is assumed to be bor- o, the amount borrowed is x( X)- Se, and

rowing from a lender (or consortium of the lenders' required expected return is

lenders) who have an opportunity cost of r(x(w)- S).

funds r. At this point our analysis is partial The Appendix shows that, under the opti-

equilibrium, in that we assume that the en- mal contract no auditing occurs when the

trepreneur's own savings (Se), the expected best possible state (here, state 2) is an-

relative price in the next period of the pro-

duced capital good (q), -and the safe rate of

return (r) are taken as exogenous. '0We are allowing general random auditing strate-

The optimal contract is found by applica- gies, which (as Townsend, 1979, first pointed out) may

tion of the revelation principle. Formally, be significantly more efficient than nonrandom strate-

the entrepreneur's problem is to maximize gies. An imphcation of permitting random auditing is

that the optimal contract will not be in the form of a

his expected next-period consumption, sub- debt contract, as it is when auditing is nonrandom

ject to the constraints that (i) the lender(s) (Dilip Mookherjee and Ivan Png, 1987; Townsend,

receive an expected rate of return of no less 1988). Importantly, our macro results are essentially the

same whether stochastic auditing is permitted or not.

Thus, we ido not have to rely on financial contracts

taking a particular debt or equity form. For our pur-

9We ignore for the moment his option of putting his poses, the important distinction is between internal and

savings into consumption-good inventories. external finance, not between debt and equity per se.

VOL. 79 NO. 1 BERNANKE AND GERTLER: BUSINESS FLUCTUA TIONS 21

nounced. Thus, for n = 2, lenders audit only ity" constraints restrict the entrepreneur's

when the entrepreneur declares the bad state ability to pay lenders if the project's out-

(state 1). Let p be the probability of an come is bad; as we shall see, the presence of

audit in the bad state, let ci be the en- these constraints is the basic reason that the

trepreneur's consumption payoff when he entrepreneur's net worth is important. (19) is

announces state i (i = 1,2) and is not au- a feasibility constraint on p.

dited, and let ca be his consumption payoff The optimal contract for n = 2 (the solu-

when he announces the bad state and is tion to (14)-(19)) is relatively simple. There

audited.11Then the optimal contract is found are two regimes: In the first regime, the

by choosing the vector { pC, C2, Ca) to entrepreneur's net worth is sufficiently large

solve12 that he is able to pay lenders their required

return even in the worst state.'4 That is,

(14) max7T1(pca+(1-p)cl)+T2C2

(20) qK1 2 r(x(c)Se).

subject to There is no agency problem in this case,

since the entrepreneur can always pay off.

(15)71 [qKlp (Ca + q-y)-(- ) Cl ] Optimal auditing probabilities are always

zero, and the lender's payoff is independent

+ '7T2qK2 - C2] ? r(x -se), of the project's outcome. This might be called

the "full-collateralization" case, since the en-

(16) C22 (1-p)(q(K2 K1)+ c), trepreneur's contribution is so large relative

to the input requirement that the lenders

(17) cl 2 O, face no idiosyncratic risk.'5 The entre-

preneur's expected consumption in the full-

(18) c >O

collateralization case, Cfc is the expected

project output less the required return to

(19) 0< p , lenders:

where q is the expected (next-period) rela- (21) Cfc= qK-r(x(w)-S)

tive price of capital.

Constraint (15) (which specializes the ap- where, recall, K = 7TIK1 + 7T2K2 is the mean

pendix inequality (A2)) requires that lenders project output.

receive an expected return of r; this con- If entrepreneurial savings se. are insuffi-

straint can be shown always to bind. Con- cient, so that (20) fails, we are in the "in-

straint (16) (which corresponds to the ap- complete collateralization" case, and there

pendix inequality (A3)) is the truth-telling will be positive agency costs. In this case the

constraint on the entrepreneur; it requires incentive constraint (16) and the "limited

that the contract be structured so that the liability" constraints (17) and (18) are bind-

entrepreneur has no incentive to misreport ing,16 as well as the outside return constraint

the good state as the bad state. (16) binds if

p > 0. Constraints (17) and (18) require that

the entrepreneur's consumption in the bad '4Recall that we are assuming that project outcomes

state be nonnegative.'3 These "limited liabil- are realized and announcements made before 9,+1 (and

thus q, +1) is known. Thus, this ability to repay needs to

hold only for the expected value of q, not for the

realized value. The alternative assumption complicates

IlMore precisely, Ca is the payoff if the entrepreneur the analysis slightly, because incentive constraints would

is audited and found to be telling the truth. The optimal depend on the realized value of q,+ ; but qualitative

payoff if the entrepreneur is audited and found to be results are unchanged.

lying is easily shown to be zero. 15If K1 = 0, then "full collateralization" requires

2The dependence of the control variables and of x Se 2 x(w).

on X is suppressed in (14)-(19). 16(17) and'(18) bind because it is optimal to concen-

A separate restriction for c2 is unnecessary, since trate the entrepreneur's payoff in the good state, thereby

(16) and (19) imply c2 > 0. minimizing his incentive to misreport.

22 THE AMERICAN ECONOMIC REVIEW MARCH 1989

diting probability p, conditional on the en-

trepreneur's announcement of state 1, is now The derivation of the optimal financial

given by contract assumed that the entrepreneur is

committed both to undertaking his invest-

(22) r(x(w)- )-qKl ment and to contributing all of his personal

,72q(K 2 K q savings to the project. As the next step to-

ward constructing a market equilibrium, we

The equation (22) is obtained from (15) now consider the effects of relaxing these

through (18), which all hold with equality in provisional assumptions.

this case. In the perfect information case, we distin-

The optimal auditing probability p is just guished two types of entrepreneurs, those

sufficient to guarantee that the entrepreneur that could profitably invest and those that

will report honestly when the good state could not. In the imperfect information case,

occurs. Under the assumptionthat 172(K2- it turns out, we must allow for three types of

-1)- 1y > 0, which we will maintain, p is entrepreneurs. For any given period t, let co

always positive when there is incomplete col- and X be the levels of entrepreneurialability

lateralization ((20) fails). (It can also be that satisfy

shown that, whenever expected entrepre-

neurial consumption is positive, p < 1.) The -

(24) qK -rx ( q-7T,y= 0,

optimal auditing probability, and thus ex-

pected agency costs (which we identify with (25) qKc-rx( ) =O.

expected auditing costs, equal to ST pQy), is

decreasing in the entrepreneur'scontribution

to the project, Se. The intuition for the Entrepreneurs with efficiency levels less than

inverse relation of Se and expected auditing X have projects whose expected net return17

costs is as follows: When Se is low, lenders is positive, even if announcements that the

require a large total return, which reduces bad state has occurred precipitate auditing

the entrepreneur's consumption in the good with probability one (p = 1). Call entre-

state. (The entrepreneur's consumption in preneurs with o < X "good" entrepre-

the bad state is always optimally zero.) With neurs. Entrepreneurs with efficiency levels

a low c2, the entrepreneur has less at risk if w < , on the other hand, are guaranteed to

he falsely claims the bad outcome when the have positive expected net returns only if

good state has occurred; thus he must be there is no auditing (p = 0), that is, when

audited more frequently. there are no dissipative agency costs; desig-

Expected entrepreneurial consumption nate entrepreneurs in this range but who are

when there is incomplete collateralization, not "good" (i.e., w < X ?< ) as "fair" en-

Cic, is given by trepreneurs.'8 Finally, "poor" entrepreneurs

(c > W) have projects that have negative ex-

pected net returns even if agency costs are

(23) c =a qK- r(x() )- zero.

Note again that, as in Section II, both w

where a ['"2q(K2 - Kl)]/[2q(K2 -

K1) and X are (increasing) functions of the ex-

q74qy]> 1. Note that aoic/ISe = ar > r; pected relative price of capital, q. Thus, our

when collateralization is incomplete, the re-

turn to "inside" funds exceeds the return to

"outside" funds. This is because additional 17

Defined as the expected value of output, less the

inside funds not only replace outside funds opportunity cost of inputs and expected auditing costs.

18i is defined exactly as in the perfect information

but also reduce expected agency costs. Hence

case; compare (8). Thus, for a given qc,both "good" and

the average "cost of capital" in this model "fair" entrepreneurs would be "profitable" under per-

depends upon the mixture of internal and fect information. (Note, though, that the value of q in

external finance. equilibrium is likely to differ in the two cases.)

VOL. 79 NO. 1 BERNANKE AND GERTLER: BUSINESS FLUCTUATIONS 23

on the value of q. z

0

Also, for any given o, let us define the _I- f / STORAGE

"full-collateralization" level of entrepre- w'1

neurial saving, S*(w), to be the quantity

that exactly satisfies (20). That is,

S se

(26) S()=x@-qlr) K,.

GOOD

An entrepreneur of type X who contributes

savings in amount greater than or equal to

S*(o) to his project will be able to borrow z INVESTMENT

and invest with zero probability of auditing 0 TRAGE

(and thus with no expected agency costs). Wa

S*(w) is a (decreasing) function of q.

We are now in a position to represent the w 0.I

opportunity sets of different types of en-

trepreneurs graphically (see Figure 2). For

each class of entrepreneurs (good, fair, or ZS / S

FAIR

poor), the solid line graphs expected en-

trepreneurial consumption (conditional on

undertaking the project) as a function of the

amount of savings contributed by the en-

trepreneur.19The dotted line, which in each z

o STORAGE

graph is a ray from the origin with slope r, is

W L _- SINVESTMENT

the opportunity cost of saving, as deter-

mined by the alternative storage technology. ,

_n .0,r

The optimal choices of each class of en- 0.

X oZ - /

trepreneur are easy to discover using Figure SO _ /

trepreneurs. For this group, the total return POOR

to storage exceeds the return to investment

for any level of savings. Thus, poor en- FIGURE 2

trepreneurs will put their savings into inven-

tory (equivalently, become lenders) and will

not undertake their projects. his own project,20 up to the point where his

Good entrepreneurs are in the opposite contribution equals S*(w); beyond this

situation. As long as the quantity of savings point, he is indifferent between investing in

that the entrepreneur contributes to his pro- his own project and either storing invento-

ject is less than the full-collateralization level ries or lending to others. If the good en-

S*(o), the marginal (and average) return to treprenur's total savings are less than S*(co),

investing in the project is greater than the his project will be audited with positive

return to holding inventories. Thus the good probability, so that agency costs are present.

entrepreneur will put all of his savings into If Se 2 S*(w), the project can be undertaken

with zero-agency costs.

The fair entrepreneur's case is a bit more

complicated. First, note that his opportunity

19This line is defined by (23) for Se < S*(w) and by

(21) for S' > S*(w), for a representative X in each

set has three regions: If Se < S'(w) (where

range. Figure 2 ignores the nonnegativity constraint on

entrepreneurial consumption. This is harmless, since, as

we shall see, entrepreneurs will not want to invest in the 2"Recall that we are assuming risk-neutrality, so that

range where nonnegativity binds. diversification is not an issue.

24 THE AMERICAN ECONOMIC REVIEW MARCH 1989

S' is defined, as in the diagram, as the level ably risk-aversion, which we exclude, is the

of savings at which the total returns to stor- major explanation. Any other factor which

age and investment are equal), the en- introduces concavity into the relationship

trepreneur will store or lend rather than between returns and wealth (for example, if

invest. If S'(w) < S' < S*(o), then the agency cost savings diminish as wealth rises;

entrepreneur will invest (contributing all his see Bernanke-Mark Gertler, 1987) would also

funds to the project), and will face a positive reduce the incentive for this sort of gam-

auditing probability. Finally, if Se > S*( X), bling.

the entrepreneur will invest and will con- For present purposes, in the spirit of

tribute enough to the project to ensure full maintaining internal consistency, we will as-

collateralization. (He will be indifferent sume that this "savings lottery" among the

about the disposition of his savings in excess fair entrepreneurs (or equivalently, between

of S*(o).) Thus the fair entrepreneur's deci- the fair entrepreneurs and, say, lenders) does

sion about whether to invest or store, as well take place. (Our basic macro results are es-

as the auditing probability if he does invest, sentially the same whether we allow the lot-

may depend on his level of savings. tery or rule it out arbitrarily.) Under this

We say "may depend" because of an inter- lottery, a fraction g(w) = S'/S*(w) of en-

esting wrinkle that arises in this case. The trepreneurs of type X win their gamble and

upper envelope of the dashed and solid lines, become fully collateralized investors; the rest

which defines the fair entrepreneur's oppor- get zero consumption and do not invest.

tunity set, is convex between zero and S*(w). The outcomes of the good and fair en-

This means that the (risk-neutral) intermedi- trepreneurs show two contrasting ways in

ate-quality entrepreneur in principle would which the quantity of borrower wealth af-

be happy to enter a fair lottery. In particu- fects investment efficiency. All investors with

lar, he would like to risk his savings in a X < X would invest in a world without infor-

lottery that pays S*(w) with probability mation problems,24 since the net returns to

S'/S*(w), zero otherwise. An entrepreneur their projects when there are no agency costs

who wins this gamble would become fully are positive. With asymmetric information,

collateralized and would be able to invest all "good" entrepreneurs still invest, but they

without agency costs; a loser gets zero con- do so with positive expected agency costs.

sumption. Ex ante, this gamble improves the These agency costs decrease in the level of

fair entrepreneur's expected utility.2' entrepreneurial savings, Se. OnlX a fraction

This incentive for extra risk-taking seems of "fair" entrepreneurs invest; those that

to arise generically in models in which agency do experience no agency costs. This occurs

costs are decreasing in the wealth of the because, as a class, the fair entrepreneurs

agent (so that there may be increasing re- become essentially self-financing. (On net,

turns to wealth over a range).22It is a legiti- the fair entrepreneurs are able to borrow

mate objection to our approach that lotteries from lenders only the difference between full

of this sort are not seen in reality.23Presum- collateralization and the input cost of their

projects.) Thus, investment by the intermedi-

ate class of entrepreneurs is restricted essen-

21This can be shown formally by modifying the tially to the amount of "internal equity"

problem (14)-(19) to allow the entrepreneur to enter they can generate. The result that en-

any fair savings lottery. Only intermediate-quality en- trepreneurs known to be more efficient can

trepreneurs will actively desire to enter such a lottery,

because of the shape of their payoff functions; good and borrow externally (albeit with a higher cost

poor entrepreneurs will be indifferent.

See Bemanke-Gertler, 1987, for another example.

Although he does not consider them, lotteries would 24Poor entrepreneurs, with w > Z5,do not invest in

also seem to ameliorate the principal-agent problem either case.

studied by Sappington. 25If lotteries were ruled out, it would still be the case

23 It does seem, though, that

people who need a that only a fraction of fair entrepreneurs invest; agency

"stake," say to open a business, may exhibit risk-loving costs would preclude the relatively less efficient ones

behavior. from undertaking projects.

VOL. 79 NO. 1 BERNANKE AND GERTLER: BUSINESS FLUCTUATIONS 25

of funds externallythan internally),but that in q and Se, and for Se 2 S*(w), we have

more marginalprojectsmust be largelyself- g(w) = 1.

financing,is at least suggestiveof real-world Again, entrepreneurs of type X > X do not

arrangements. invest.

Total capital formation (per head) in this

C. Within-PeriodEquilibrium case is given by

We show now how the expectedprice and (29) kt+l= [KS-7lyf P(w)d@] q

the quantity of new capital are determined

within a period, given the inheritedcapital

stock, and assumingy > 0. + [K g() dco]q,

In any period t, the inheritedper capita

capital stock kt is predetermined.With la- where the expression in the first set of brack-

bor supplied inelastically,output is deter- ets reflects capital formation (net of auditing

mined by the productionfunction and the costs) by good entrepreneurs,and the second

randomproductivityshock 9 (compare(1)). expression in brackets is capital formation

The wage and therefore lender and en- by fair entrepreneurs. (29) can be rewritten

trepreneurialsavingin t are determined. as

We would like to know the supply and

demand curves for capital.Considerthe de- (30) k, 1= {KI-[J7Tf7P(co) dC

termination of capital supply, for a given

expected relative price of capital, q.26 For

w< definep(w) to be the probabilitythat

o, ++ K(I- g(w) d@J)q [SS].

an entrepreneurof type w is audited(in the

bad state).The functionp(w) is definedby (30) is the capital supply curve for the

y > 0 case. It is depicted in Figure 3 as the

S'S' curve, along with the perfect informa-

- qK,-

(27)

( ) p (w) ~((Axw

( ) =max rx(W) -4c rSe

rSe)

- tion capital supply curve (SS) (derived in

4q(72(K2 -K1) -1y Section II) for reference. Several points can

be made about the S'S' curve.

for w < X (compare(22)). p(o) is decreasing First, S'S' lies to the left of SS, that

in q and in Se; p(c) = 0 for Se ?s*(c-4 is, capital supply is always less in the imper-

Fair entrepreneurs(with types between o fect information case. ((From (9) and (10),

and Z), becauseof the "collateralization lot- kt+?1=Kc'q when y=0; from (30), kt+I<

tery,"do not face the agencycost of auditing Kw q when -y> 0.) This is because imperfect

when they invest; but only the fraction of collateralization when y > 0 increases the

fair entrepreneurswho win the lottery are agency costs for those projects undertaken

able to invest. Let g(w), definedfor X < o < and (perhaps more significantly) leads to a

co, be the fraction of fair entrepreneursof decline in the number of projects that can be

type cowho can invest (and 1- g(&o)be the profitably initiated.

fraction who are excluded).Using the fact Second, the S'S' curve is upward-sloping

that g(o) = Se/S*(w), and substituting from in (qf?1, kt+,) space. This can be verified by

(26), we have differentiating the expression for kt+1 in (30)

with respect to qt+ , using (27), (28), and the

definitions of X and X ((24) and (25)). (Note

(28) g( o) = min( ,14

A ) that the dependence of the cutoff efficiency

rx(f) qKl

levels X and X on qt+1 must be explicitly

for X < X < W. The quantityg(w) increases taken into account.) Since as q gets large

enough the system approaches "full collater-

alization" (p ( X) and 1 - g( w) approach

26,~

q means qt+ . We continue to drop the time sub- zero), the S'S' and SS curves coincide at

script where there is no ambiguity. high values of q.

26 THE AMERICAN ECONOMIC REVIEW MARCJI 1989

A

S min rise in current income, emanating from an

q +I D /S increase in either the inherited capital stock

k, or the value of the productivity shock Ot.

In either case young entrepreneurs (as well

as young lenders) will accumulate more sav-

SI ~ ~ ings. Higher entrepreneurial saving (Se) low-

ers agency costs and therefore shifts the S'S'

s ~ ~ / curve down to the right, raising kt,j and

k lowering qt, . This effect is not present in

the perfect information case. We see, there-

fore that the presence of agency costs in-

duces a channel of dependence of invest-

min max ment on income as long as the incentive

constraint binds for some entrepreneurs.

FIGURE 3 Second, imagine a redistribution of (labor)

endowment from entrepreneurs to lenders,

that is, raise L and lower Le so that -qLe+

Third, unlike that of the SS curve, the (1 - -q)L is still equal to one. The motivation

position of the S'S' curve depends on a for this exercise is to model an aspect of

period-t state variable, namely, entrepre- "debt-deflation," a situation in which a com-

neurial savings Se (which enters into the bination of unindexed debt contracts and

expressions for p7() and 1- g(w)). High unexpected deflation redistributes wealth

values of Se (which move the system closer from the debtor class to the creditor class.29

to full collateralization)push the S'S' curve A fall in Le lowers Se, shifting the S'S' up

down toward the SS curve; lower values of to the left; qt,l rises and kt,j falls. Thus

Se move the S'S' curve up and away from a redistribution from borrowers to lenders

the SS curve. S'S' reachesits farthestpoint depresses capital spending. The intuition is

from SS when Se is at its minimumvalue.27 that lower entrepreneurial wealth raises the

The dashed line marked S'S(mIa) in Figure 3 agency costs associated with capital finance,

describes this boundary. reducing the net return to investment.30

The determination of the demand for cap-

ital is much simpler: Capital demand in the D. Dynamics

ty>f case is given by the identical DD curve

as in the

oy =t case (equation ( 3)). The We are now equipped to consider aggre-

intersection of S'S' and DD (see Figure 3) gate dynamics for the -y> 0 case.

determines capital formation in period t. As we have already seen, the (benchmark)

Output which is saved it m ums not in- perfect information (-y= 0) case has no in-

vested is stored, to be consumed in the sub- teresting dynamics; the capital stock is fixed

sequent period. This fully determines the

within-period equi0cbriuma. o

Two useful comparative statics results fol- 29The original discussion of debt-deflation is Fisher,

1933. See Bernanke, 1987, and James Hamilton, 1987,

low directly. First, consider the ebect of a for some evidence that debt-deflation was an important

feature of the Great Depression. Why debt contracts are

in practice typically unindexed is a deep puzzle which

27Given L', the minimum possible value of se occurs we will not discuss here.

when wages are minimum, which in turn occurs when 30If we had assumed diminishing rather than con-

capital per head is zero and 9 is at its minimum stant returns to the storage technology, the debt-defla-

possible value. Assumptions made above suffice to guar- tion (by driving a larger share of savings into storage,

antee that this minimal wage is positive. the alternative asset) would also cause the safe rate of

28 Condition (3) guarantees that the S'S('in) curve return to fall; this is the "flight to quality" phe-

intersects the vertical axis below the DD curve, so that nomenon. Note though that, since q rises, debt-defla-

investment is positive no matter how severe the agency tion cannot explain a stock market crash without intro-

problem. For an analysis of investment collapse in- ducing additional factors (such as aggregate demand

duced by agency problems, see Bernanke-Gertler, 1987. externalities).

VOL. 79 NO. I BERNANKE AND GERTLER: BUSINESS FLUCTUA TIONS 27

and production varies only with the produc- matically, 9* is the minimum realization of

tivity shock 0. The y > 0 case is different 9 which makes the capital supply curve (S'S')

because of the dependence of the capital exactly overlap the perfect information sup-

supply curve on entrepreneurial savings Se. ply curve (SS), given k, = kma. In this case,

The S'S' curve is shifted by variations in a realization of 9 above 9* has no effect on

either the current capital stock kt or the investment. The S'S' does not move outward

productivity shock Ot,either of which affects since all the efficient entrepreneurs are al-

the value of the entrepreneurs'labor endow- ready fully collateralized. In contrast, a real-

ments and thus their savings. Thus future ization of 9 below 9*, by pushing some

capital depends on both current capital and entrepreneurs below full collateralization and

productivity, leading to a nontrivial dynam- moving the S'S' curve left, induces an in-

ics. vestment downturn.

Consider how a productivity shock is An explicit characterization of the sto-

propagated over time when y > 0. In the chastic steady state of this model cannot be

informationally constrained region, a (tem- obtained without some additional assump-

porary) rise in 0 stimulates investment by tions (for example, about functional forms).

increasing entrepreneurial net worth (since We may note several points, however: First,

incomes increase). The S'S' curve shifts as long as some part of the support of 9 is

rightward. The expansion persists because below 9*, then even if the economy begins at

the rise in the future capital stock makes kmax, there is some probability that it will be

investment in the subsequent period high- in the informationally constrained region in

er than it would otherwise be. Through the next period. Second, if the economy be-

the same mechanism, negative productivity gins at the minimum possible equilibrium

shocks may induce a persistent investment capital stock kmin (at the intersection of the

downturn. This is our attempt to capture in DD and S'Smi. curves), and assuming that 9

a formal model the following sort of intu- is a nondegenerate and continuously dis-

ition: In good times, when profits are high tributed random variable, the capital stock

and balance sheets are healthy, it is easier will almost certainly rise over time. Third,

for firms to obtain outside funds. This stimu- independent of initial conditions, the equi-

lates investment and propagates the good librium capital stock in each period (it is

times. Conversely, poor financial health in easy to show) will lie in the interval

bad times reduces investment and reinforces [kmin,km,j. We conclude that for most

the decline in output. Note again that this plausible parameterizations the system will

rationalizes a sort of accelerator effect of be in the interior of the informationally con-

income on investment; note also that coun- strained region with some positive probabil-

tercyclical agency costs are crucial to the ity in any given period, even asymptotically.

story. A distributional shock, as described in

The dynamic effects of productivity dis- Section III, Part C, will also initiate interest-

turbances may be asymmetric in this setup. ing dynamics. In particular, a redistribution

(Sharp investment downturns are more likely from borrowers to lenders that does not af-

than sharp upturns.) For example, suppose fect total income will lower investment not

the initial level of capital equals the value only in the current period, but for a number

the economy attains under perfect informa- of subsequent periods as well. Thus balance

tion; denote this value as kmax.Next, for the sheet considerations may initiate, as well as

casekkm= av let

9* be the minimum value propagate, cyclical fluctuations.

of 0 which generates a level of Se large

enough to make all "good" and "fair" en- IV. Conclusion

trepreneurs fully collateralized.31 Diagram-

We have constructed a simple neoclassical

model of intrinsic business cycle dynamics in

Given (6), (25), (26), and (13), O*is defined by 9*= which borrowers' balance sheet positions

[x(-) - (4(k ..)Ir) ic,]/[ f(k ..) -f '(kmx) kmax 1 play an important role. The critical insight

28 THE AMERICAN ECONOMIC REVIEW MARCH 1989

is that the agency costs of undertaking phys- ciency and policy are taken up at greater

ical investments are inversely related to length in our 1987 paper. In particular, that

the entrepreneur's/borrower's net worth. paper discusses whether a policy of "debtor

As a result, accelerator effects on invest- bailouts" (redistributions from lenders to

ment emerge: Strengthened borrower bal- borrowers) may be desirable when borrower

ance sheets resulting from good times ex- net worth is low. Also addressed there is the

pand investment demand, which in turn issue of whether agency costs typically lead

tends to amplify the upturn; weakened bal- to "under"- or "over" - investment on aver-

ance sheets in bad times do just the opposite. age.

The aggregate effects of productivity shocks Finally, it is important to find out whether

may be asymmetric (since the agency prob- the qualitative results of this paper go

lem may only bind on the "down" side). through when borrowers and lenders are able

Further, redistributions or other shocks that to make contacts that last many periods.

affect borrowers' balance sheets (as may oc- This has been done by Gertler (1988). In an

cur in a debt-deflation) will have aggregate n-period setting, he shows that the concept

real effects. of "borrower net worth" should be aug-

We have investigated extensions of this mented to include not just current endow-

approach in related work. Our 1987 paper ments (as in the present paper), but also the

studies the macroeconomic implications of " most secure" portion of expected future

agency costs in a richer model of the invest- profits; thus, agency costs depend not only

ment process. In that model, projects differ on current wealth but also on expected fu-

ex ante (not just ex post, as in the costly ture conditions. He demonstrates that this

state verification model), borrowers are able can induce additional interesting cyclical dy-

to obtain private information about project namics into the aggregate economy.

quality by incurring an evaluation cost, and

borrowers must decide whether to proceed APPENDIX: OPTIMAL CONTRACTING

with projects that they have evaluated. The WITH STOCHASTIC AUDITING

analysis of that model shows that the con-

This appendix studies the optimal financial contract

cept of "agency costs" relevant to macroeco- between risk-neutral33 entrepreneurs and lenders when

nomic fluctuations is much broader than the there is private information about project outcomes but

monitoring costs of the present paper: lenders have access to a costly auditing technology, as

"Agency costs" should include any deviation described in the text. We allow explicitly for a random-

ized auditing strategy by the lenders. As in the main

from first-best outcomes associated with the text, we are assuming that borrowing and investment

necessity of external finance (whether it be occurs in a given period t, and that project realization,

through debt or other instruments). This re- auditing, and "settling up" by entrepreneursand lenders

sult is important for interpreting the model occurs in t + 1. Settling up is done via transfers of the

empirically. Our companion paper also veri- produced capital good, and takes place before the pe-

riod-(t +1) value of capital, in terms of the consump-

fies the robustness of this basic approach to tion good, is known. Time subscripts are omitted below

variations in assumptions about endowments for legibility.

and the information structure, and to per- There are n possible outcomes of the investment

mitting coaliti'ons among entrepreneurs. project. In state i, Ki units of the capital good are

We have not discussed policy implications produced. Assume 0 < K, < K2 < *.. < K, and denote

the probability of the ith outcome by ri, 7i > 0. After

in the present paper. While, as in most OG

models, the competitive solution of our

model economy is not guaranteed to be

Pareto optimal, it is efficient in a limited, to manipulate the relative price of capital in order to

intra-generational sense.32 Issues of effi- relax incentive constraints.

33The assumption of risk-neutrality differentiates our

analysis from that of Townsend, 1988, and Mookherjee

and Png, 1987, who consider the risk-averse case. Inter-

32Our dynamic equilibrium replicates the solution to estingly, the risk-neutral case seems to avoid some ap-

a planning problem in which there are restrictions on parent anomalies that can arise in the optimal contract

intergenerational trades and the planner is not allowed with risk aversion.

VOL. 79 NO. 1 BERNANKE AND GERTLER: BUSINESS FLUCTUATIONS 29

privately observing the true state j, the entrepreneur and one, (A6) and (A7). The first-order conditions for

announces a state, say k, to the lenders. The lenders can ca, c' (i= 2.n), cl, c (i = 2 n-1), c, Pi, P1

verify the true state only by incurring an auditing cost (i = 2,..., n - 1), and pn are, respectively,

of -y units of capital. We assume that lies of the form

k < j are feasible; in this case, the entrepreneur can (A8) 71Pi (1- Xi)+ A41= O

"hide" the extra capital Kj - Kk. The expected value of

this hidden capital is 4(K -Kk) units of consumption, i-1

where q is the expected relative price of capital. Lies of

the form k > j are assumed infeasible, that is, the

(A9) 7ipi (l- X1) + Pi E -2ij+ 04i= ?

j=1

entrepreneur cannot show the lenders produced capital

that does not exist.

We look for the optimal incentive-compatible con-

tract. Let ci be the entrepreneur'scontractual consump-

(Al0) 7T,(1 -Pp) (1 -AX)

tion when he announces outcome i and is not audited,

and let c' be his consumption when he announces i, is n

audited, and is found to be telling the truth. (It is

-(-pl) Y X2k?+X31=0

straightforward to show that the entrepreneur's optimal k= 2

consumption when he is audited and found to be lying

is zero (see Mookherjee and Png, 1987); we impose this

from the beginning.) We allow a general stochastic

(All) 7Ti(1 - pi)(1 - Xj) + (1 - pi) X2iA

auditing strategy: The lenders can commit in advance to j =1

auditing an announcement of outcome i with probabil-

ity pi. The total input cost of the project is x (here we n

hold the entrepreneur's "efficiency," w, fixed). The en-

trepreneur's contribution is his savings Se, and the

-('-Pi) E X2ki+X3i=?

k i+ 1 )

interest rate is r, so that the lenders' total required

return is r(x - Se). The entrepreneur's(borrower's) for-

mal problem is

(Al+2) (+nK(1k-Kpn)))(+l- X + -

n

{c4,c.Pi} i= 1

+ (1c-PO) A2nj

Z + X3n=?

j =1

subject to

n (A13) 1( i-i~~~~~

oriA)i is-imm-editlqy

(A2) 7Ti

[ q'Ki -(Pi Cia+ (1 -Pi ) Ci)-P jY] n

i =1

+ (+q(-s)Ak+ l-6=

k= 2

2 r(x - Se) (1)

Addigth diffeee - 1 H

i=2,...n j<i (X2ij)

+(ia- 1: 2ij

j =1

(A4) ci>O i=1,2,..., n (3i)

n

(A5) cpa i=1,2,...,n (n 4 ) + E ( ci + '(Kk - KM)) 2ki + X5i - 6i =

k =i+ 1

2

(A6) Pi 0 i 1,2, ... , n ( 05i)

(A15 ) ( Ca-c

7Tn 1A

straints are in the right margin in parentheses, and q is "Y + ( cn- 6n = ?.

-A17n Cn) 1: X2nj +n As-

the expected value of q,, . The entrepreneur's objec- j =1

tive, (Al), is to maximize expected consumption, subject

to the constraint that lenders receive their required

return (A2), the truth-telling constraint (A3), nonnega- From (A8) or (A9), it is immediate that A1 > 1, so

tivity constraints on c, and cia, (A4) and (A5), and the that the lenders' return constraint (A2) always binds.

restriction that auditing probabilities be between zero Adding the difference between the LHS and RHS of

30 THE AMERICAN ECONOMIC REVIEW MARCH 1989

(A2) to the objective (Al) reveals that the problem is the value of ci is irrelevant.) Comparing (All) and

unchanged if we replace (Al) with (A9), note that the first two terms of (All) are propor-

tional to - X4i. If X4i > 0, then (All) implies X3i > 0

n

and we are done. Suppose that X4i = 0. Then, in (A14),

(Al)' min E 7,qpiy. the first and third terms, which are proportional to X4i,

Pi} =

{c4a.Ci. disappear. Since X5i = 0, for (A14) to hold there must

Thus we have be some k > i such that X2ki > 0. (All) then again

implies X3i > 0, so that ci - 0.

Result 1. The optimal contract minimizes expected

auditing costs, subject to the constraints (A2)-(A7).

Result 1 and the fact that (A2) binds imply that Result 5. The entrepreneur receives no consumption

expected auditing costs under the optimal contract are in the worst state; cl = cl = 0.

nondecreasing in the return required by lenders (the

RHS of (A2)). For fixed r, this required return is PROOF:

decreasing in Se, the collateral of the entrepreneurs. X41 > 0 (if Pi > 0) and X31> (if PI < 1) follow

Thus we have immediately from (A8) and (A10).

Result 2. Expected auditing costs under the optimal

contract are nonincreasing in the quantity of the en- Result 6. Let C' = pic' + (1- pi)ci be the en-

trepreneur's collateral Se (and they are strictly decreas- trepreneur's expected consumption in state i. Then cj is

ing in Se when expected auditing costs are positive at nondecreasing in i, that is, the entrepreneur does better

the initial point). in better states.

We have noted that X1?1. There are two interesting

subcases, X1= 1 and X1> 1. If X1= 1, then we are in the PROOF:

case of no auditing; that is, pi= 0, all i. (Proof: If For some ci, we wish to show that ck 2 Lj, any k > i.

X1= 1, then from (A9) we have PiX2iJ= 0 (i = 2,..., n; cl = 0, so let i >. If X3i> 0 and X4i > 0, then c' = 0

j < i). (A12) and the fact that PnX2nj= 0 implies X2nJ and the result is immediate. Suppose instead then that

= 0, j < n. Using (All) and working recursively back- either X3i = 0 or A4i = 0. Then from (All) or (A9),

ward from i = n - 1, we conclude X2ij = 0 (i = there exists some j < i such that >2ij> 0. This implies

2,..., n; j < i.) From (A13)-(A15), this implies X5i> 0, =(l- p)(Cj + (K K ))For any k > i, we know

all i; that is, pi = 0.) On the other hand, if pi > 0 for fromi (A3) that Ck 2 (1- pj)(Cj + 4(Kk - Kj)) > (1-

any i, then X1> 1. (Proof: If some pi > 0, then AX5= 0. pj)(Cj + q(Ki - Kj)) = ci. Thus expected consumption is

Suppose that X1= 1. From (A13)-(A15), AX5= 0 implies actually strictly increasing in the range where it is

that some X2ij or X2ki must be positive. But, as shown positive.

just above, this implies X1> 1, a contradiction.)

Consider first the no-auditing case (Xl = 1). With no Result 7. There is never any auditing in the highest

auditing there is no deadweight loss; the "first best" is state; p, = 0.

attained. The next result characterizes when this is

possible. PROOF:

Result 3. The optimal contract involves no auditing if Suppose p,n> 0. Then X5n= 0 and, from Result 4,

and only if the lender's required return is less than the cn = 0. Now if c' = 0 also, (A15) can hold only if

value of the worst possible outcome of the project; that X5n> 0, and we have a contradiction. Suppose instead

is, pi=O, all i, iff r(x-Se) qKl that c' > 0. Then X4n= 0 Comparing (A15) with (A9),

we see that the first and third terms of (A15), which are

PROOF: proportional to X4n, must be zero. But then once again

Suppose pi = 0, all i. From (A3), this implies ci > (A15) can hold only if X5n> 0, a contradiction.

q(Kc - K1), i = 2,..., n. Substituting this into (A2) yields

r(x - Se) < q'cK, which proves sufficiency. Now suppose Result 8. The probability of auditing is nonincreasing

r(x - Se) < q'c1. Then the contract {ci = q'Ki - r(x - in the announced state (pi is nonincreasing in i).

se), p = 0, cj irrelevant} satisfies the constraints and

involves no auditing. Since auditing costs are mini- PROOF:

mized, this contract is optimal, by Result 1. For any pi, i = 2,..., n -1, we wish to show that

Pi-l 2 Pi. If pi = 0, this is trivial, so take pi > 0. By

When r(x - Se)> qKI, we are in the case X1> 1, and Result 4, c = 0. Now there are two possibilities to

the optimal contract involves some positive probability consider, c' = 0 and c' > 0.

of auditing. We give a few results for this case (X1 > 1 is Suppose cf' = 0. Then for (A14) to hold, there

maintained). must be some k > i such that X2ki> 0. Thus Ck=

Result 4. In any state in which there is a positive (1 - Pi)(q(k - Kj)), where ck is defined as in Result 6.

probability of auditing, the entrepreneur receives posi- We know that ck 2 (1-Pi-l)(c-1 + q(K - Ki1))

tive consumption only if he is audited; that is, pi > 0 Since c1 + 4(qk - K1) > 4(Kk - Ki), it must be that

ci = 0. Pi-1 ? Pi.

If c' > 0, then 4i = 0, and the first and third terms

of (A14), which together are proportional to X4, equal

PROOF: zero. For (A14) to hold, there must again be some k > i

Our proof is for i = 2,...,n - 1; similar arguments such that X2ki > 0, and the argument is the same as

apply for i = 1 and i = n. Assume 1 > pi > 0. (If pi = 1, before.

VOL. 79 NO. 1 BERNANKE AND GERTLER: BUSINESS FLUCTUA TIONS 31

formation, Finance Constraints, and Busi-

ness Fluctuations," unpublished manu-

Bernanke,Ben and Gertler,Mark, "Financial script, June 1986.

Fragility and Economic Performance," Hamilton,James D., "Monetary Factors in the

NBER Working Paper No. 2318, July Great Depression," Journal of Monetary

1987. Economics, March 1987, 19, 145-69.

"Nonmonetary Effects of the Finan- Holmstrom,Bengt, "Moral Hazard and Ob-

cial Crisis in the Propagation of the Great servability," Bell Journal of Economics,

Depression," American Economic Review, Spring 1979, 10, 74-91.

June 1983, 73, 257-76. Mishkin, Frederic, "The Household Balance

Diamond,Douglas, "Financial Intermediation Sheet and the Great Depression," Journal

and Delegated Monitoring," Review of of Economic History, December 1978, 38,

Economic Studies, July 1984, 51, 393-414. 918-37.

Diamond, Peter, "Government Debt in a Mookherjee, Dilip and Png, Ivan, "Optimal

Neoclassical Growth Model," American Auditing, Insurance, and Redistribution,"

Economic Review, December 1965, 55, unpublished manuscript, revised April

1126-50. 1987.

Eckstein, Otto and Sinai, Allen, "The Mecha- Prescott, EdwardC., "Theory Ahead of Busi-

nisms of the Business Cycle in The Post- ness Cycle Measurement," Quarterly Re-

war Era," in Robert Gordon, ed., The view, Federal Reserve Bank of Minneapo-

American Business Cycle: Continuity and lis, Fall 1986, 9-33.

Change, University of Chicago Press for Sappington, David, "Limited Liability Con-

NBER, 1986. tracts Between Principal and Agent,"

Farmer,Roger, "A New Theory of Aggregate Journal of Economic Theory, February

Supply," American Economic Review, De- 1983, 29, 1-21.

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Fisher,Irving,"The Debt-Deflation Theory of nomic Equilibrium and Credit Rationing,"

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ber 1933, 1, 337-57. Townsend, Robert, "Optimal Contracts and

Gale, Douglas and Hellwig,Martin,"Incentive- Competitive Markets with Costly State

Compatible Debt Contracts I: The One- Verification," Journal of Economic Theory,

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Studies, October 1985, 52, 647-64. _ "Information Constrained Insur-

Gertler, Mark, "Financial Capacity, Reliq- ance: The Revelation Principle Extended,"

uification, and Production in an Economy Journal of Monetary Economics, March/

with Long-Term Relationships," unpub- May 1988, 21, 411-50.

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Green,Edward,"Lending and the Smoothing tion, Business Failures, and Real Business

of Uninsurable Income," unpublished man- Cycles," Journal of Political Economy, De-

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