Limited Commitment, Firm Dynamics and Aggregate Fluctuations

Limitations in the punishment for default induce constraints in the credit of firms and a non-trivial dynamics for their growth. Those limitations can also shape the dynamic response of the overall economy in response to an aggregate shock. In this paper I consider a simple continuous time formulation of the optimal dynamic relationship between a banks and a firm and derive a simple and sharp characterization of the optimal contract, the implicit credit constraints (for an equivalent sequentail trading arrangment) and the implied firm dynamics. I analytically characterize the steady state firm size distribution and show how to solve the optimal contract under any arbitrary deterministic path of the economy-wide equilibrium prices. I use the results to study the aggregate response to interest rates and aggregate productivity fluctuations. I also study the output and welfare cost of limited commitment.