Creator: Boyd, John H. and Smith, Bruce D. (Bruce David), 1954-2002 Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 512 Abstract:
We investigate ex-ante efficient contracts in an environment in which implementation is costless. In this environment, standard debt contracts will typically not be optimal. Optimal contracts may involve defaults, even in states in which the borrower is fully able to repay. We then examine the welfare costs of arbitrarily restricting the set of feasible contracts to standard debt contracts. When model parameters are calibrated to realistic values, the welfare loss from exogenously imposing this restriction is extremely small. Thus, if the implementation costs are actually nontrivial (as seems likely), standard debt contracts will be (very close to) optimal.
Keyword: Ex ante contract, CESV, CSV, Loans, Costly ex-post state verification, Contracts, Bankruptcy, Debt, Costly state verification, Standard debt contract, Optimal contract, and Financial contract Subject (JEL): G10 - General Financial Markets: General (includes Measurement and Data) and D86 - Economics of Contract: Theory