Efficient Allocations in a Dynamic Moral Hazard Economy

I analyze the implications of moral hazard in dynamic economy with production. In particular, I add agency frictions to a benchmark stochastic growth model, by assuming that firms observe output but hours worked and productivity are unobservable. I cast the problem as a continuous time principal agent model and study the contracting problem that results. I solve for the optimal contract using some recent results on the validity of the first-order approach in continuous time, which makes the analysis tractable. I show that the dynamic agency frictions introduce both a "labor wedge" which distorts the allocation of labor within a period and an "intertemporal wedge" distorting the allocation of consumption over time. I analyze the quantitative importance of moral hazard in this economy for consumption and output dynamics and asset prices.