Optimal debt contracts and moral hazard along the business cycle

Summary. We analyze the Pareto optimal contracts between lenders and borrowers in a model with asymmetric information. The model generalizes the Rothschild-Stiglitz pure adverse selection problem by including moral hazard. Entrepreneurs with unequal abilities borrow to finance alternative investment projects which differ in degree of risk and productivity. We determine the endogenous distribution of projects as functions of the amount of loanable funds, when lenders have no information about borrowers ability and technological choices. Then, we embed these results in a dynamic competitive economy and show that the average quality of the selected projects in equilibrium may be high in recessions and low in booms. This phenomenon may generate (a) multiple steady states, (b) a smaller impact of exogenous shocks on output relative to the full information case, (c) endogenous fluctuations.Received: 11 June 2001, Revised: 17 June 2003, JEL Classification Numbers: A10, G14, G20, E32.Correspondence to: Pietro ReichlinPietro Reichlin acknowledges financial support from MURST and Paolo Siconolfi acknowledges financial support from the GSB of Columbia University.