money and credit in liquidity provision abstract this paper studies the liquidity provision in a model where the roles of money are challenged by other financial instruments alternative to money credit can be used as means of payment and rate dominating assets are available to serve as stores of value two features are found to be crucial in rendering money valuable in this environment information asymmetry in credit trading relationship and uncertainty in individuals liquidity demand in general the model economy can display a payment mechanism of money only credit only or mixed use of money and credit in transactions depending on the severity of the information asymmetry the optimal quantity of money in our paper is shown to contrast those in other monetary models

inflation financial markets and long run real activity abstract empirical evidence suggests that real activity the volume of bank lending activity and the volume of trading in equity markets are strongly positively correlated at the same time inflation and financial market activity are strongly negatively correlated in the long run as are inflation and the real rate of return on equity inflation and real activity are also negatively correlated in the long run particularly for economies with relatively high rates of inflation we present a monetary growth model in which banks and secondary capital markets play a crucial allocative function we show that at least under certain configurations of parameters the predictions of the model are consistent with these and several other observations about inflation finance and long run real activity

optimal vs traditional securities under moral hazard this paper provides an explanation for the widespread use of traditional securities by wellestablished firms standard moral hazard models predict that equity debt and warrants are almost never optimal financing instruments i show that issuing these securities is nevertheless nearly optimal the issuer would gain very little by using non traditional securities instead combined with equity one debt issue without multiple layers of seniority and one warrant issue without multiple exercise prices suffice to achieve near optimality the near optimality of traditional financing depends crucially on the issuer s ability to use war rants in addition to debt and equity

social culture and economic performance the connection between obtaining higher paying jobs and undertaking some seemingly irrelevant activity is interpreted as social culture in the context of a society trying to adopt a new technology i show that by allowing the firms to give preferential treatment to workers based on some cultural activity the society can partially overcome an informational free riding problem therefore social culture may affect the economic performance by altering the effective production technology of the economy jel p17 z1 what is social culture what is the role of social culture in economic performance in a provocative article kenneth arrow 1971 argued that norms of social behavior including ethical and moral codes are reactions of society to compensate for market failure somewhat surprisingly this idea of the role of social culture has not been further pursued in the literature in this paper i take arrow s viewpoint seriously and construct a simple model to examine the possibility that social culture may alleviate market failure i consider a society that is deciding whether to adopt a new technology three important assumptions are made about the economy first adoption decisions are made by entrepreneurs or firms but the operators of the new technology are workers second the new technology can be successfully operated only when the worker has invested in some imperfectly observable requisite skills and third it is costly for the workers

how good are standard debt contracts stochastic versus nonstochastic monitoring in a costly state verification environment the authors investigate ex ante efficient contracts in an environment in which implementation is costless in this environment standard debt contracts will typically not be optimal optimal contracts may involve defaults even in states in which the borrower is fully able to repay the authors then examine the welfare costs of arbitrarily restricting the set of feasible contracts to standard debt contracts when model parameters are calibrated to realistic values the welfare loss from exogenously imposing this restriction is extremely small thus if implementation costs are actually nontrivial as seems likely standard debt contracts will be very close to optimal copyright 1994 by university of chicago press

costly intermediation and the poverty of nations this article has two goals i to reduce the 7 fold productivity differential required to explain the observed 33 fold income difference between the richest and poorest countries of the world and ii to explain cross country differences in the capital output ratio to achieve the first goal we modify the production function of the standard neoclassical growth model to include public capital whose provision is subject to intermediation costs for the second goal we distort private investment by introducing credit frictions the model quantified using cross country data generates an income gap of 33 with productivity differences of only 3 under the measured variations in public and private capital the required productivity gap declines even further to 2 1 when we introduce a home production sector on the second goal however credit frictions do a poor job of explaining cross country variations in the capital output ratio

capital market imperfections and the theory of optimum currency areas this paper studies how within and cross country capital market imperfections affect the welfare effects of forming a currency union the analysis considers a bank only world where intermediaries compete in cournot fashion and monitoring and state verification are costly the first part determines the credit market equilibrium and the optimal number of banks prior to joining the union the second part discusses the benefits from joining a currency union a competition effect is identified and related to the added monitoring costs that banks may incur when operating outside their home country through an argument akin to the brander krugman reciprocal dumping model of bilateral trade however in our framework whether joining a union raises welfare of the home country is ambiguous it depends on the relative strength of investment creation and intermediation diversion effects

the dynamic structure of optimal debt contracts abstract in a two period model of costly state verification the optimal contract is characterized and shown to exist the optimal contract is interpreted as a bond contract the model extends the result of one period models that the verification region must be a left tail interval to a multi period setting conditions are identified for the optimal contract to exhibit features such as call prepayment option coupon payment or sinking fund the optimality of certain bond covenants such as refinancing covenants and dividends covenants is also studied

costly monitoring financial intermediation and equilibrium credit rationing abstract this paper establishes a link between equilibrium credit rationing and financial intermediation in a model with asymmetrically informed lenders and borrowers costly monitoring and investment project indivisibilities intermediation is shown to dominate borrowing and lending between individuals and these financial intermediaries exhibit several of the important features of intermediaries as we know them equilibrium interest rates and the aggregate quantity of loans respond quite differently to changes in taste and technology parameters depending on whether or not there is rationing in equilibrium

asymmetric information and demand for money in an overlapping generations economy this paper studies a pure exchange overlapping generations economy in which agents have asymmetric information pertaining to their income realizations such an information asymmetry introduces a role for fiat money that would otherwise be absent this information asymmetry can also drastically alter the equilibrium properties of the analogous model with perfect information in general the more severe the information asymmetry the greater the demand for fiat money

a theory of corporate capital structure and investment this article uses a general equilibrium framework to explore the origins and limitations of financial intermediaries in the model investors have a generic lending technology that they can improve at a cost those who upgrade become intermediaries to exploit their advantage however conflicts with depositors will limit the banks market presence and they will only lend to moderately endowed firms while bondholders will finance cash rich corporations the article also analyzes the extent to which investors adopt the superior lending technique the nature of bank competition and how corporate and bank conditions affect interest rates and investment copyright 2004 oxford university press

reserve requirements on sovereign debt in the presence of moral hazard on debtors or creditors this paper characterises the effects of reserve requirements on financial loans in the presence of moral hazard on the lender side and sovereign risk on the borrower side the impacts of such reserve requirements on the equilibrium default risk and borrowing are analysed and their welfare implications discussed more generous bailouts financed by the high income block encourage borrowing and increase the probability of default the optimal reserve requirements for both lender and borrower are characterised the

repeated insurance relationships in a costly state verification model with an application to deposit insurance abstract we consider the problem of an insurer who enters into a repeated relationship with a set of risk averse agents in the presence of ex post verification costs the insurer wishes to minimize the expected cost of providing these agents a certain expected utility level we characterize the optimal contract between the insurer and the insured agents we then apply the analysis to the provision of deposit insurance our results suggest in a deposit insurance context that it may be optimal to utilize the discount window early on and to make deposit insurance payments only later or not at all

moral hazard under commercial and universal banking many claims have been made about the potential benefits and the potential costs of adopting a system of universal banlcing in the united states we evaluate these claims using a model where there is a moral hazard problem between banks and borrowers a moral hazard problem between banks and a deposit insurer and a costly state verification problem under conditions we describe allowing banks to take equity positions in firms strengthens their ability to extract surplus and exacerbates problems of moral hazard the incentives of universal banks to take equity positions will often be strongest when these problems are most severe for many decades commercial banks in the united states have been prohibited from making equity investments in the firms they serve rather they are restricted to providing them with loans in the form essentially of debt contracts this longstanding regulatory restriction1 results in distinctly different roles for bank lenders and equity investors and has had important implications for the entire financial sector the american system of commercial banking presents a sharp contrast with the banking systems of some other countries most notably germany in which banks are permitted to take equity positions under such universal banking arrangements banks can make equity investments as well as loans vote their equity shares and even hold seats on the boards of directors of nonfinancial firms in general they can be actively involved in all aspects of firm decision malqing in germany the control rights the authors have benefitted from the helpful comments of doug diamond joe haubrich ross levine stan longhofer joao santos and an anonymous referee the views expressed herein are those of the authors and not necessarily those of the federal reserve bank of minneapolis or the federal reserve system 1 the key legislation which constrains u s banks equity investments is the glass steagall act of 1933 however a number of other laws also pertain to this issue particularly the bank holding company act of 1956 and its 1970 amendments incidentally there are some important exceptions to the equity investment prohibition in default situations banks are perrnitted to restructure loans into equity positions with the requirement of divestiture after a few years see james 1993 also bank holding companies are permitted to form separately capitalized venture capital subsidiaries for the expressed purpose of investing in start up enterprises john h boyd is a professor of finance in the carlson school of management at the university of minnesota and an adjunct consultant with the federal reserve bank of minneapolis chun chang is an associate professor of finance in the carlson school of management at the university of minnesota bruce d smith is a professor of economics at the university of texas ataustin

the coevolution of the real and financial sectors in the growth process the role of debt and equity changes over time and with the level of development what are these changes and why should they systematically occur across different countries and time periods this article characterizes financial innovation as a dynamic process that both influences and is influenced by the development of the real sector it focuses on the emergence and development of equity markets using a model that allows for growth and for capital accumulation that is financed externally through a combination of debt and equity as an economy develops the aggregate ratio of debt to equity will generally fall yet debt and equity remain complementary sources for the financing of capital investments the results suggest how various government policy actions might affect capital accumulation and equity market activity

capital market imperfections international credit markets and nonconvergence abstract we consider a two country growth model with international capital markets these markets fund capital investment in both countries and operate subject to a costly state verification csv problem investors in each country require some external finance but also provide internal finance which mitigates the csv problem when two identical except for their initial capital stocks economies are closed they necessarily convergemonotonicallyto the same steady state output level unrestricted international financial tradeprecludesotherwise identical economies from converging and poor countries are necessarily net lenders to rich countries oscillation in real activity and international capital flows can occur journal of economic literatureclassification numbers e00 f00 f34 g14

financing development the role of information costs to address how technological progress in nancial intermediation aects the economy a costly state veri cation framework is embedded into the standard growth model the framework has two novel ingredients first rms dier in the risk return combinations that they oer second the e cacy of monitoring depends upon the amount of resources invested in the activity a nancial theory of rm size results undeserving rms are over nanced deserving ones under funded technological advance in intermediation leads to more capital accumulation and a redirection of funds away from unproductive rms toward productive ones quantitative analysis suggests that nance is important for growth

financial market frictions monetary policy and capital accumulation in a small open economy abstract we consider a small open economy with a costly state verification problem and binding reserve requirements the presence of these frictions leads to the existence of two steady states with credit rationing an increase in the money growth rate the world interest rate or reserve requirements raises lowers gdp in the high low activity steady state however sufficiently large increases in money growth or the world interest rate can transform the high activity steady state from a sink to a source the model also delivers prescriptions for restoring the stability of this steady state in such an eventuality journal of economic literatureclassification numbers e5 f4

financial intermediation and delegated monitoring this paper develops a theory of financial intermediation based on minimizing the cost of monitoring information which is useful for resolving incentive problems between borrowers and lenders it presents a characterization of the costs of providing incentives for delegated monitoring by a financial intermediary diversification within an intermediary serves to reduce these costs even in a risk neutral economy the paper presents some more general analysis of the effect of diversification on resolving incentive problems in the environment assumed in the model debt contracts with costly bankruptcy are shown to be optimal the analysis has implications for the portfolio structure and capital structure of intermediaries

costly state verification with varying risk preferences and liability abstract in the scenario of loan contracts with costly state verification we examine how the properties of the set of states different risk preferences of debtors and varying liability of lenders affect the structure of optimal repayments in particular we show that with risk averse debtors a general set of states a constant observation cost and both unlimited and limited lender liability the debtor is strictly better off revealing the true state of nature when his realized revenue is low which implies that optimal debtor consumption has a downward jump around the single switch from observed to unobserved states if the debtor can destroy revenue or if the debtor is risk neutral this non monotonicity of consumption disappears moreover given the loan size there is more monitoring under debtor risk aversion than risk neutrality we present simulations showing that a contract with unlimited lender liability and debtor risk aversion has a higher expected observation cost but a lower variance of consumption than a contract with limited lender liability finally we discuss the problems of commitment to verification and contract renegotiation in this framework

capital structure under costly enforcement we consider financial structure and repayment behavior in a setting where cash flows are private information to the entrepreneur and the cost of enforcing repayment differs across security holders if enforcement costs are lower for shareholders than for creditors a mixed capital structure with debt and equity can obtain in equilibrium under a mixed capital structure creditors intervene in low cash flow states while shareholders intervene in high cash flow states moreover strategic defaults costly bankruptcy shareholder intervention and violation of absolute priority occur with positive probability on the equilibrium path several of the predictions from our framework are consistent with evidence not readily explainable by existing theories

bankruptcy costs and the new bankruptcy code bankruptcy costs are the deadweight economic costs of firms going bankrupt they include both ex post bankruptcy costs incurred after a firm s bankruptcy filing such as transactions costs and ex ante bankruptcy costs incurred before the filing such as those resulting from creditors attempts to reduce their losses if bankruptcy occurs and or managers attempts to raise the expected return to equity by increasing the firm s risk 1 this paper has two purposes first it proposes a model of bankruptcy costs which focuses on the costs of inefficient decision making before the firm s actual bankruptcy filing the model implies upper bound expressions for total bankruptcy costs second the new u s bankruptcy code2 went into effect late in 1979 and made important changes in bankruptcy reorganization procedures the paper poses the question of whether the changes made under the new code tend to raise or lower aggregate u s bankruptcy costs we approach this question by calculating the upper bound expressions suggested by the model using parameter values from both before and after the new code took effect from an economic standpoint the most important changes instituted under the new bankruptcy code had the effect of making it more difficult to reorganize firms in bankruptcy previously it was common for failing firms to file for bankruptcy but for prior management to continue to operate the firm in much the same form as before the bankruptcy filing prevented unpaid creditors from suing the firm while a reorganization plan was arranged which cut back most debts from an economic standpoint such a procedure was anomalous since we learn in basic economics that competition in the long run should cause inefficient firms to go out of business as long as failing firms are more likely to be inefficient than firms in general it would seem to be rewarding inefficiency and offsetting

costly monitoring loan contracts and equilibrium credit rationing this paper develops a model with asymmetrically informed agents and costly monitoring of loan contracts where an equilibrium can exhibit credit rationing borrowers are identical ex ante but some receive loans and others do not in contrast to existing credit rationing theories rationing does not occur here due to inflexible prices adverse selection or moral hazard optimizing behaviour produces a standard debt contract in equilibrium the aggregate quantity of loans and equilibrium interest rates respond differently depending on whether there is rationing in equilibrium

what can we learn from simulating a standard agency model abstract for typical parametrizations of the standard bell journal of economics 10 1979 74 agency model this paper demonstrates that the set of first order conditions characterizing the optimal contract can be reduced to a single equation a problem of investment financing under moral hazard is used to illustrate the reduced form equation s usefulness in quantitative applications when the agent has cara preferences over consumption it is shown that any exogenous limit on the penalties for low output is always binding

optimal monetary policy and downward nominal wage rigidity in frictional labor markets empirical evidence suggests that nominal wages in the u s are downwardly rigid this paper studies the optimal long run inflation rate in a labor search and matching framework under the presence of downward nominal wage rigidity dnwr in this environment optimal monetary policy targets a positive inflation rate the annual long run inflation rate for the u s is around 2 percent positive inflation greases the wheels of the labor market by facilitating real wage adjustments and hence it eases job creation and prevents excessive increase in unemployment following recessionary shocks these findings are related to standard ramsey theory of wedge smoothing by following a positive inflation policy under sticky prices the monetary authority manages to reduce the volatility and the size of the intertemporal distortion significantly the intertemporal wedge is completely smoothed when prices are fully flexible since the optimal long run inflation rate predicted by this study is considerably higher than in otherwise neoclassical labor markets the nature of the labor market in which dnwr is studied can be relevant for policy recommendations

samurai accountant a theory of auditing and plunder a risk neutral principal wishes to exact a payment from a risk neutral agent whose wealth he does not know but may verify through a costly auditing procedure we characterize efficient schemes for the principal when he is allowed to choose schedules for preaudit and postaudit payments and audit probabilities subject to the constraint that only monetary incentives can be used and that the principal may never make a net payment to the agent the main results are that efficient schemes involve preaudit payments which are increasing in the agent s wealth audit probabilities are decreasing in the agent s wealth and also satisfy certain constraints as equalities in general such schemes involve stochastic auditing and rebates after an audit in this paper we analyse the problem of a principal extracting wealth from an agent who is reluctant to part with it and is also better informed than the principal as to the amount he owns we assume that the principal has a costly means of discovering the agent s

stochastic costly state verification and dynamic contracts abstract i consider a dynamic costly state verification environment in which a risk averse agent enters into a contract with a risk neutral principal the agent has random income which is unknown to the principal but can be verified at a cost the principal can commit to executing random verifications i extend the standard recursive methods to study the problem and show that it is optimal to set verification probabilities strictly less than 1 if the agent s absolute risk aversion declines sufficiently slowly the principal will use verification regardless of its cost if the agent s income is verified then he would get consumption and continuation utility strictly higher than if his income were not verified