Implicit Contracts with Asymmetric Information and Bankruptcy: The Effect of Interest Rates on Layoffs

This paper develops a model in which a firm writes labour contracts with workers and debt contracts with creditors. Firms have more information than do the owners of the factors of production and they are also subject to limited liability. We show that if the limited liability constraint is binding then the employment level is inefficient relative to a situation of symmetric information. The firm is then embedded into a partial equilibrium model in which the real rate of interest is exogenously determined. We show that increases in the real rate of interest increase the inefficiency of the optimal employment contract and lead to layoffs in more states of nature than would occur at lower real interest rates.