A theory of dynamic contracting with financial constraints

Abstract Financial constraints preclude many surplus producing economic transactions, and inhibit the growth of others. This paper models financial as interaction two forces: agent has persistent private information is strapped for cash. The wedge between optimal efficient allocation, termed distortion, increases over time with each successive “bad shock” decreases “good shock”. At any point in contract, an endogenous number shocks” are required principal to provide some liquidity then eventually contract become efficient. Efficiency reached almost surely. average rate at which becomes decreasing persistence shocks; particular, iid model predicts a quick dissolution constraints. speaks relevance modeling dynamic agency. problem solved recursively, building on literature, technical tool finding minimal subset recursive domain that houses further developed.