Capital accumulation under different financial agreements

This paper develops a simple overlapping-generations model where agents’ income is given both by a stochastic endowment and by the profits generated by a production activity. The purpose is to analyze the consequences of different forms of financial agreements on capital accumulation. In this model, Pareto optimality requires that the capital stock is a deterministic function of the previous level of capital. Agents can eliminate any randomness in the capital-accumulation process when contingent claims markets are available. When standard loan contracts prevail because of asymmetric information, the economy incurs an efficiency loss due to capital-stock fluctuations. The expected level of capital under this last regime is always smaller than the one achieved when markets for contingent claims exist.