Aggregate fluctuations, financial constraints and risk sharing

Summary. Private information and costly state verification often result in credit rationing in models with smooth investment, affecting both loan size and total investment. The optimal contract is derived in a dynamic stochastic growth model with capital for two types of models: one with symmetric information and the other with asymmetric information and costly state verification. When all information is observed costlessly, the equilibrium optimal contract provides complete insurance to risk-averse savers against aggregate fluctuations. When information is asymmetric and there is costly state verification, the equilibrium optimal contract provides only partial insurance against aggregate shocks. The extent of insurance is measured by the marginal rate of transformation of consumption between borrowers and lenders which is closely linked to the user cost of capital. The deadweight monitoring costs create a wedge between a borrower's cost of capital and a lender's stochastic discount factor, with two results: (i) fluctuations in the user cost of capital provides a mechanism by which aggregate shocks can be␣propagated; (ii) the distribution of capital's share of output among borrowers, lenders, and monitoring costs varies even if capital's share is constant. Capital market frictions not only amplify aggregate fluctuations but also generate cross-sectional fluctuations that may not be observable in aggregate data. Received: November 17, 1997; revised version: April 20, 1998