Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/60800
Authors: 
Donaldson, John B.
Gershun, Natalia
Giannoni, Marc P.
Year of Publication: 
2011
Series/Report no.: 
Staff Report, Federal Reserve Bank of New York 531
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. A generic family of compensation contracts similar to those employed in practice is studied. When compensation is convex in the firm's own dividend (or share price), 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. Incentive contracts of sufficient yet modest convexity are shown to result in an indeterminate general equilibrium, one in which business cycles are driven by self-fulfilling fluctuations in the manager's expectations that are unrelated to the economy's fundamentals. Arbitrarily large fluctuations in macroeconomic variables may result. We also provide a theoretical justification for the proposed family of contracts by demonstrating that they yield first-best outcomes for specific parameter choices.
Subjects: 
delegation
executive compensation
indeterminacy and instability
JEL: 
E32
J33
Document Type: 
Working Paper

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