Contracts, Relationships, and Real Activity

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The aim of this project is to provide a new understanding of markets for capital, labor and other productive inputs, based on developing a clear accounting of the factors shaping long-term relationships that make up the markets. This inquiry focuses on two key dimensions. (1) The success of relationships depends on their ability to overcome contracting imperfections, such as limited liability, limited liquidity, and limited verifiability of actions. (2) Market outcomes are determined by the processes that bring agents together to form relationships, as well as the success of relationships in solving their contracting problems. Economic productivity, propagation of shocks, and the effectiveness of policy intervention are all tied to the formation, operation and breakdown of long-term relationships.The project consists of three main parts. The first part consists of a new theoretical model of credit markets in which liquidity is channeled from lenders to entrepreneurs through long-term relationships, and lenders may be constrained in their short-run access to liquidity. Relationships are subject to inefficient breakdown due to limited liability and limited liquidity. Outflows of aggregate liquidity induce persistent damage to financial structure by breaking up relationships. Complementarily between returns to investment and the structure of intermediation leads to multiple steady-state equilibria having different levels of aggregate liquidity, including a collapse state that may become the unique equilibrium outcome following a severe negative shock. The model is extended to consider relationships between multiple entrepreneurs and lenders, and the dynamics of policy intervention will be analyzedThe second part formulates and tests empirical implications of the model. The model predicts that greater availability of loanable funds to the banks in a state, as proxied by bank deposits or bank capital positions, should relate positively to real activity in the state. Further, greater cross-sectional dispersion of funds across banks should reduce real activity. The proposed research will test these implications using bank balance sheet data and state-level measures of economic activity as well as assessing the significance of liquidity allocation for the transmission of monetary shocks.The third part develops a stochastic dynamic monetary equilibrium model that couples the theoretical model of credit markets with the limited participation mechanism for producing nominal rigidity. The expanded model will yield important improvements in the amount of persistence of output responses, and the sluggishness of price responses, following monetary shocks, relative to previous models.