Finance and Economics Discussion Series (FEDS)
Aggregate Consequences of Dynamic Credit Relationships
Which financial frictions matter in the aggregate? This paper presents a general equilibrium model in which entrepreneurs finance a firm with a long-term contract. The contract is constrained efficient because firm revenue is costly to monitor and entrepreneurs may default. The cost of monitoring firms and the entrepreneurs' outside options determine the significance of moral hazard relative to limited enforcement for financial contracting. Calibrating the model to the U.S. economy, I find that the relative welfare loss from financial frictions is about 5 percent in terms of aggregate consumption with moral hazard, while it is 1 percent with limited enforcement. Reforms designed to strengthen contract enforcement increase aggregate consumption in the short-run, but their long-run effects are modest when monitoring costs are high. Weak contract enforcement contributes to aggregate fluctuations by amplifying the effect of aggregate technological shocks, but moral hazard does not.
Keywords: Business cycles, financial contracting, financial development, firm dynamics, limited enforcement, private information
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