Financial Capacity, Reliquification, and Production in an Economy with Long-Term Financial Arrangements

Abstract

This paper characterizes a multi-period production economy in which borrowers and lenders enter long-term financial contracts. A key feature is that aggregate production and borrowers' capacity to absorb debt -- their "financial capacity" - are jointly determined endogenous variables, in the spirit of Gurley and Shaw (1955) Expectations of future economic conditions govern financial capacity, which in turn influences current capacity utilization. Further, disturbances in the present may persist into the future by influencing borrowers' net asset positions. Finally, borrowers may substitute future for current production by preserving their assets in hard times, behavior akin to reliquification as described in Eckstein and Sinai (1986).