Bernanke and Gertler Agency Costs, Net Worth and Business Fluctuations Lender costs of “auditing” borrowers put a wedge between the costs of inside capital and outside capital. The higher an entrepreneur’s net worth (saving), the easier it is to attract credit and to undertake investment projects. Positive productivity shocks increase income, increase entrepreneur saving, reduce agency costs of securing credit, increase current investment…and increase capital stock making for greater future output and investment. Negative shocks push some entrepreneurs out of a “good” category  greater negative effects on investment and future output. Redistribution “shocks” from borrowers (entrepreneurs) to lenders reduce borrower net worth and reduce investment. Debt-deflation shocks reduce borrower net worth and similarly reduce investment.

Garrett Jones’ (GMU) Summary Two kinds of people: Entrepreneurs (E) and Savers (S) Technology shocks  Variations in Output, Income, Saving (E Net Worth) Entrepreneurs don’t have enough saving to reap full benefits of their ideas Savers could lend to entrepreneurs who could tell them their projects failed even when they were successful  Lenders incur auditing costs (“costly state verification”) Set audit probability so E won’t lie when his project succeeds S’s willing to lend more when the future is promising – Less chance they’ll incur auditing costs

Normal times S does some lending to E though some projects not funded Some E are unlucky, fail to repay S, and might get audited Negative aggregate shock E have less collateral (net worth) to back their ideas S can’t trust E as much: Less trust  Less Lending  Less Investment  Less future Y A one-time negative shock can set off long recession E’s productivity down  E’s collateral down  Less trust  Reduced saving and lending by S  Reduced investment  Reduced capital stock and output in future