A Model of Dynamic Liquidity Contracts

I study long-term lending and borrowing in the absence of perfect enforceability and when lenders as well as borrowers are capital constrained. Borrowers receive random investment opportunities and need external financing. Lenders can commit to contractual agreements whereas borrowers can renege any period. Economy exhibits efficient investment cycles; absence of perfect enforcement and shortage of capital skew the cycles toward states of liquidity drought; credit is rationed if either the lender has too little capital or if the borrower has too little collateral. This paper's technical contribution is its demonstration of the existence and characterization of financial contracts that are solutions to a non-convex dynamic programming problem