Income fluctuation and asymmetric information: An example of a repeated principal-agent problem
We examine a simple repeated principal-agent model with discounting. There are a risk averse borrower with an unobservable random income and a risk neutral lender. The efficient contract is characterized. It tends to the first-best (constant consumption) contract as the discount factor tends to one and the time horizon extends to infinity. If the time horizon is infinite and the contract is legally enforceable the borrower’s utility becomes arbitrarily negative with probability one. If the borrower has constant absolute risk aversion consumption is transferred between any two states at a constant interest rate which is less than the rate of time preference.