Contractual issues in the financing of new firms: macroeconomic and policy implications

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The research described in this proposal is directed to understanding the link between the contractual arrangements used to finance new firms and their growth and the volatility of the aggregate economy. The ability to attract external financing is crucial for the creation of new firms and the expansion of existing ones. For that reason the nature of the financial arrangements between lenders and firms has important consequences for the growth of firms. It also can have important consequences for the propagation of aggregate shocks and the volatility of the aggregate economy. This research project has three objectives. First, it studies how contractual problems affect the optimal financing of new firms and their subsequent growth. Second, it evaluates the welfare costs of these contractual problems that result because they induce an inefficient allocation of resources and studies the type of policies or institutions that alleviate these welfare consequences. Third, it studies how contractual problems affect the propagation of new investment opportunities in the macro-economy.To pursue these objectives, the project integrates the two main approaches to studying the impact of financial frictions on the investment behavior of firms. The first approach focuses on the primary sources of frictions that prevent market completeness, and the implications of this incompleteness for the behavior of individual firms. It fails to consider, however, issues of macroeconomic relevance. The second approach is concerned with the aggregate implications of market incompleteness. Given its aggregate focus, in this approach market incomplete-ness is exogenously imposed, rather than derived endogenously. Because the properties of these models depend critically on the type of financial frictions assumed, it is desirable that these frictions are endogenously generated in the model rather than imposed by assumption. This is especially important for the design of policies and institutional arrangements aimed at improving the inefficiencies generated by limited contractability.The project integrates the existing approaches to the study of financial market incompleteness, by developing a general equilibrium model with a solid micro-foundation for the incompleteness. Entrepreneurs have the ability to run an entrepreneurial project over a long time but need external funds to finance investment. Entering into a long-term relationship with a lender through an optimal long-term contract solves the financing problem. Market incompleteness derives from the ability of the entrepreneur to repudiate the financial contract (i.e. from the limited enforceability of contracts). By integrating the existing approaches to the study of market incompleteness, the model is able to address theoretical and policy-related questions. The general equilibrium structure facilitates the evaluation of the welfare costs of market incompleteness, while the micro-foundations permit the analysis of the type of policies or institutional arrangements that can support a superior allocation of resources.