Agency Costs, Balance Sheets and the Business Cycle

Abstract

The views expressed in this paper are ours alone and do not necessarily reflect the views of the Reserve Bank of Australia. We are grateful to Warren Tease, Gordon de Brouwer and participants at seminars at the Reserve Bank of Australia and the The 1980s witnessed large increases in corporate debt and sustained asset price inflation. More recently, asset prices, particularly commercial property prices, have fallen significantly. The effect of these changes on balance sheets, and their implications for the business cycle, have generated considerable interest among academics and policy makers. In this paper, we review recent theoretical models that link the evolution of the business cycle to changes in firm equity. This link arises out of the asymmetry of information between borrowers and lenders and between managers and owners. These asymmetries lead to distortions in decision making which affect both the supply of and demand for credit, and ultimately investment and output. Deteriorations in the net worth of corporations and financial institutions are likely to lead to a reduction in both credit demand and supply and to