Dynamic costly state verification

Summary. I study a model of dynamic risk sharing with costly state verification (CSV). In the model, a risk neutral agent enters an infinitely repeated relationship with a risk averse agent. In each period, the risk averse agent receives a random income which is observed only by himself, unless the risk neutral agent engages in costly monitoring. I provide a set of characterizations for the optimal contract, and I show that CSV has interesting effects on the long run distribution of the agents expected utilities.Received: 19 February 2003, Revised: 11 February 2004, JEL Classification Numbers: D8.This research was initially joint work with Bruce Smith. I thank Bruce for the inspiration. I thank Fernando Alvarez, Narayana Kocherlakota, Steve Spear, and an anonymous referee for helpful comments. I also thank seminar participants at Carnegie Mellon University, Federal Reserve Banks of Minneapolis, Federal Reserve bank of Richmond, Duke University, SUNY Buffalo, University of Rochester, University of Pittsburgh, University of Western Ontario, the 1998 Econometric Society winter meeting, the 1999 SED meeting, and the 1999 SITE workshop at Stanford University for discussions.