Investment Decisions, Financial Flows, and Self-Enforcing Contracts

Christian Sigouin

International Economic Review, 2003, vol. 44, issue 4, 1359-1382

Abstract: This article studies the role of risk sharing in dynamic credit relationships that are secured by physical collateral. It is shown that, when borrowers and lenders cannot commit not to terminate relationships (through default in the first case and liquidation in the second), overinvestment is optimal. Overinvestment facilitates risk sharing in this context: It occurs in expectation of periods in which lenders are unwilling to supply all the funds necessary to achieve complete risk sharing. Typically, overinvestment happens when investment decreases; it slows down the pace at which the capital stock is reduced and therefore results in production smoothing. Copyright 2003 by the Economics Department Of The University Of Pennsylvania And Osaka University Institute Of Social And Economic Research Association.

Date: 2003
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