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American Economic Association

Agency Costs, Net Worth, and Business Fluctuations

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
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American Economic Review.
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.

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.

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."

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).

mation into the model, we assume that the

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).

(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

between investing and storing satisfies

(8) qt+-K rx(W) 0.

The projects of entrepreneurs with efficiency

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

(9) qs e + (I1-n)S > |x(X) dw, FIGURE 1

for any -, for any realization of 0, and for

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],

(10) t where, recall, 0 is the mean of Ot+I and f'

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.

(12) qt+?=rx(kt+?/K'q)/K [SS]

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.

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.

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.

(15) (which always binds). The optimal au- B. The EntrepreneurialInvestmentDecision

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.)

classification of entrepreneurs is conditional INVESTMENT

on the value of q. z
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,.
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
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
graph is a ray from the origin with slope r, is
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 _ /

2. Consider first the poor, or inefficient, en- S Se

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.

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.

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,-
( ) p (w) ~((Axw
( ) =max rx(W) -4c 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
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.

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).

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

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.

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= ?
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 + -

(Al) max i(piCa + (1_ Pi) Ci) n-1

{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)

(A3) picia+ (l-pi)ci 2(l-pj)(cj +q'(Ki-K M) (A14) 7ti(Cha-Ci)(l-eld u cstiqy

Addigth diffeee - 1 H
i=2,...n j<i (X2ij)
+(ia- 1: 2ij
j =1
(A4) ci>O i=1,2,..., n (3i)
(A5) cpa i=1,2,...,n (n 4 ) + E ( ci + '(Kk - KM)) 2ki + X5i - 6i =
k =i+ 1
(A6) Pi 0 i 1,2, ... , n ( 05i)

(A7) 12> Pi i1, 2,. . . , n (A6i )

(A15 ) ( Ca-c
7Tn 1A

where the multipliers associated with each set of con- n-

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

(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
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.

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