Nber Working Paper Series Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts

We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. Delegation gives rise to a generic conflict of interest mediated by a convex (option-like) compensation contract which is able to align the interests of managers and their shareholders. With such a compensation contract, a given increase in the firm's output generated by an additional unit of physical investment results in a more than proportional increase in the manager's income. We find that incentive contracts of this form can easily result in an indeterminate general equilibrium, with business cycles driven by self-fulfilling fluctuations in the manager's expectations. These expectations are unrelated to fundamentals. Arbitrarily large fluctuations in macroeconomic variables may possibly result. John B. Donaldson Columbia Business School 3022 Broadway, Uris Hall New York, NY 10027-6902 [email protected] Natalia Gershun Pace University Lubin School of Business 1 Pace Plaza New York, NY 10038. [email protected] Marc P. Giannoni Columbia Business School 3022 Broadway, Uris Hall 824 New York, NY 10027-6902 and NBER [email protected]