The recent resurgence of federal government budget deficits has rekindled debates about the effects of government debt on interest rates. While the effects of government debt on the economy can operate through a number of different channels, many of the recent concerns about federal borrowing have focused on the potential interest rate effect.
Higher interest rates caused by expanding government debt can reduce investment, inhibit interest-sensitive durable consumption expenditures, and decrease the value of assets held by households, thus indirectly dampening consumption expenditures through a wealth effect. The magnitude of these potential adverse consequences depends on the degree to which federal debt actually raises interest rates.
Regulatory reform in the wake of the recent financial crisis has focused on an increase in capital cushions of financial intermediaries. Basel III rules have doubled the minimal capital ratio, and directed banks to hold excess capital as conservation and counter cyclical buffers above the minimum (BIS, 2010). These arrangements complement traditional moral suasion and individual targets used by regulators to ensure adequate capital cushions.
We study the optimal contract between well-diversified risk-neutral shareholders and a constant relative risk aversion (thereafter CRRA) manager in a continuous-time agency model. In our model, the manager controls the instantaneous growth rate of an output process. Cost of effort is assumed as a standard quadratic function. A number of interesting results are obtained.
