Some unpleasant general equilibrium implications of executive incentive compensation contracts

This paper presents preliminary fi ndings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the authors and are not necessarily refl ective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. authors thank Christian Hellwig, as well as an associate editor and an anonymous referee, for very helpful comments and suggestions. The views expressed in this paper are those of the authors and do not necessarily refl ect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Abstract We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the fi rm on their behalf. A generic family of compensation contracts similar to those employed in practice is studied. When compensation is convex in the fi rm's own dividend (or share price), a given increase in the fi rm's output generated by an additional unit of physical investment results in a more than proportional increase in the manager's income. Incentive contracts of suffi cient yet modest convexity are shown to result in an indeterminate general equilibrium, one in which business cycles are driven by self-fulfi lling fl uctuations in the manager's expectations that are unrelated to the economy's fundamentals. Arbitrarily large fl uctuations in macroeconomic variables may result. We also provide a theoretical justifi cation for the proposed family of contracts by demonstrating that they yield fi rst-best outcomes for specifi c parameter choices.