Working Paper: NBER ID: w15165
Authors: John B. Donaldson; Natalia Gershun; Marc P. Giannoni
Abstract: We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. Delegation gives rise to a generic conflict of interest mediated by a convex (option-like) compensation contract which is able to align the interests of managers and their shareholders. With such a compensation contract, a given increase in the firm's output generated by an additional unit of physical investment results in a more than proportional increase in the manager's income. We find that incentive contracts of this form can easily result in an indeterminate general equilibrium, with business cycles driven by self-fulfilling fluctuations in the manager's expectations. These expectations are unrelated to fundamentals. Arbitrarily large fluctuations in macroeconomic variables may possibly result.
Keywords: Executive Compensation; General Equilibrium; Business Cycles; Convex Contracts
JEL Codes: E32; J33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| additional investment (G31) | manager's income (M12) |
| convex executive compensation contracts (M12) | manager's behavior regarding investment decisions (G11) |
| manager's beliefs about future returns (G17) | current consumption and investment decisions (E20) |
| convex executive compensation contracts (M12) | sunspot equilibria (D50) |
| managerial expectations (D84) | macroeconomic volatility (E32) |
| degree of contract convexity (D86) | indeterminate equilibria (D59) |