Endogenous Risk, Incentives and Aggregate Fluctuations
This paper analyzes a model in which incentive constrained
contracting implies both amplification and intertemporal
propagation of technology shocks. In the model risk averse agents
choose between a riskless technology and a risky technology (`the
entrepreneurial activity') with higher expected return but also
with moral hazard. Under the optimal contract, entrepreneurs need
to bear more risk when productivity is low. This renders agents'
technology choices procyclical, i.e., more agents become
entrepreneurs when productivity is high, which in turn amplifies
technology shocks. The technology choices and hence the amount of
entrepreneurial activity can be correlated across time even if
technology shocks are independent. The propagation is asymmetric
and results in long expansions and short, `sharp' recessions. We
think that our model complements the existing literature on the
effects of countercyclical agency costs by pointing out an
additional mechanism that renders agency costs countercyclical. In
our model it is the risk associated with the entrepreneurial
activity rather than constraints on outside funding (due to the
limited resources of the entrepreneur) that constrains the amount
of entrepreneurial activity.
In contrast to the literature
on the effects of financial contracts on aggregate dynamics which
typically considers one period financial contracts only, we study
(in work to be completed) both one period and multiperiod (two
period) contracts and show that multiperiod contracts have
important effects on the dynamic properties of aggregates. Thus,
restricting attention to one period contracts importantly alters
the implications for aggregate dynamics. We provide a
characterization of optimal two period contracts and find that:
(i) entrepreneurs who are unsuccessful early on are most likely to
be credit constrained and (ii) incentive constraints are more
stringent in the second period of a contract and thus compensation
is optimally delayed towards that period (which may be interpreted
as the accumulation of `internal funds').