Uncertainty, Incentives, and Misallocation

Published date01 October 2020
Date01 October 2020
DOIhttp://doi.org/10.1111/jmcb.12672
DOI: 10.1111/jmcb.12672
SEUNGJUN BAEK
Uncertainty, Incentives, and Misallocation
This paper identifies a new propagation mechanism by which the effects
of business cycle shocks amplify in the context of the dynamic stochas-
tic general equilibrium framework. Business cycle shocks, such as height-
ened uncertainty, and positive monetary shocks endogenously magnify the
cross-sectional dispersion in idiosyncratic productivity. This induces en-
trepreneurs, who have asset substitution incentive, to distort the quality of
an investment project, which amplifies the response of investment and out-
put. Moreover, lenders reallocate credit from firms with a high marginal
product of capital, in which the asset substitution problem is more preva-
lent, to firms with a low marginal product of capital, which in turn further
depresses aggregate economic activities. A policy that subsidizes lenders
to firms with a high marginal product during a recession improves the al-
location of loans. Empirical evidence from the NBER-CES Manufacturing
Industry Database provides support for the model’s predictions.
JEL codes: E32, E44, G14
Keywords: financial frictions, business fluctuations, moral hazard.
UNCERTAINTY HAS ATTRACTED AN INCREASING attention as
a potential factor driving business cycle fluctuations. This paper proposes an
asset substitution/risk-shifting channel by which the effects of uncertainty shocks
propagate. Although there is a large corporate finance literature on asset substitution
problems starting with Jensen and Meckling (1976), existing business-cycle models
with financial frictions do not take into account the endogenous behavioral responses
of entrepreneurs to underlying economic environments.1I argue that the asset sub-
stitution channel can be crucial in amplifying and propagating business fluctuations
through uncertainty shocks. In this regard, the paper contributesto a growing literature
I would like to thank Ricardo Reis for invaluable advice and support over the course of this project.
I would also like to thank two anonymous referees, Mikhail Dmitriev, Jaromir Nosal, J´
on Steinsson,
Michael Woodford, and seminar participants at Columbia University and Florida State University for
helpful discussions. Any errors are my own.
SEUNGJUN BAEK is at Florida State University (E-mail: seungjun.baek@fsu.edu).
Received August 7, 2017; and accepted in revised form May 7, 2019.
1. Some empirical evidence supports the risk-shifting hypothesis. For financial firms, see Esty (1997),
Gan (2004), and Landier, Sraer, and Thesmar (2015). For nonfinancial firms, see Eisdorfer (2008),
Lelarge, Sraer, and Thesmar (2010), and Stromberg and Becker (2010).
Journal of Money, Credit and Banking, Vol.52, No. 7 (October 2020)
C
2020 The Ohio State University
1822 :MONEY,CREDIT AND BANKING
on uncertainty and business cycle fluctuations; for example, Christiano, Motto, and
Rostagno (2014) (CMR). It also complements recent papers by identifying the new
channel by which business cycle shocks propagate in the context of a DSGE model.
The framework of the model builds on Bernanke and Gertler (1989) and Bernanke,
Gertler, and Gilchrist (1999) (BGG). I generalize the BGG framework with the asset
substitution channel and nest it as a special case. The key idea that distinguishes this
paper from earlier work is that the distribution of the idiosyncratic productivity of an
individual project is endogenous. This is because entrepreneurs, who play a central
role in the model, must pay some costs of exerting effort in order to raise the probabil-
ity of identifying a better project. This new feature leads to a moral hazard problem and
adds entrepreneurs’ incentive compatibility constraint to the original BGG problem.
In the model, entrepreneurs engage in an investment project, which can be either
good or bad. For each project, idiosyncratic productivity is drawn from a stochastic
process that depends on the type of project. A good project is better than a bad project
in the sense that the mean idiosyncratic return is greater, while the standard deviation
of the idiosyncratic return (uncertainty) is smaller than the other. Identifying a good
project, however, is costly for entrepreneurs.
The realization of an idiosyncratic return remains unknown to lenders. Moreover,
information asymmetry between lenders and entrepreneurs implies that lenders also
cannot observe the level of effort entrepreneurs exert. The unobservability of effort
leads entrepreneurs to pursue their hidden benefit, which may conflict with lenders’
interests. Once a financial contract is written, entrepreneurs, who are protected by
limited liability, may gain more by engaging in risky projects in which expected
returns in nondefault states are higher. This risk shifting is costly for lenders as it
raises expected bankruptcy costs. This new feature implies that the optimal contract
must be incentive-compatible.
The model demonstrates that an uncertainty shock, which is an increase in the
cross-sectional standard deviation of an idiosyncratic return, has an important effect
on investment and output. In the BGG framework, CMR emphasize the importance
of uncertainty shocks driving the business cycle.2I show that the asset substitution
channel amplifies the effects of uncertainty shocks on aggregate outcomes in two
ways. First, from the perspective of entrepreneurs, an increase in uncertainty raises
the value of a bad project, net of the cost of effort.3It leads entrepreneurs to shift the
riskiness of a project in favor of a bad project, by choosing a lower level of effort.
As a result, the dispersion of idiosyncratic productivity is amplified endogenously
in response to an uncertainty shock. Second, the level of effort is negatively related
to the level of debt in the incentive compatibility constraint.4This implies that a rise
in uncertainty, which tightens the incentive compatibility constraint, increases the
2. Uncertainty shocks in this paper are the same as risk shocks in Christiano, Motto, and Rostagno
(2014).
3. With a debt contract, entrepreneurs hold a portfolio consisting of (i) claims on equity and (ii) a
long position in a put option on projects with strike price ¯
D, below which entrepreneurs default. A rise
in the uncertainty increases the value of a put option on a bad project.
4. As in footnote 3, the value of a put option on a bad project is increasing in the level of debt ¯
D.

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