lending to other entrepreneurs. This means some agents in this economy may be
lending assets to some other agents they never see.
One additional difficulty is that there is a continuum of these agents. Banks
have to keep track of all the capital exchanges among agents, and this may be
expensive. As in Lucas [18], one possibility that reduces the cost of following bor-
rowing and lending is to record balances only and to forget about the information
of who borrows from whom. These balances are maintained in a unit of account
called “credit” created by banks in the process of intermediation. Entrepreneurs
in need of capital borrow these units of account to rent capital from the rest of
agents who deposit these credits in accounts at the bank. These credits exchange
for capital goods at a nominal price P . Depositors receive a nominal rate RD per
credit deposited and borrowers pay a nominal rate RL per credit borrowed. When
these rates are received, the credits are exchanged for capital goods at the price P .
At the beginning of each period, the representative bank has a supply D of these
credits to be determined below. Also notice that, when production takes place,
workers are in the firms to collect the goods so there is no need for a medium of
exchange for consumption goods and wages.
There are two costs of being an entrepreneur. On the one hand, there is the
opportunity cost of foregone wages which represent an endogenous barrier to entry
for entrepreneurs. In this sense, it will determine a minimum size of the firm below
which it is more profitable to become a worker. On the other hand, we assume
full information and no possibility of default in financial contracts.4 Because the
sizes of the firms have to be chosen before effective skills for the period are known,
there is always the risk of drawing a low productivity shock and realizing negative
profits that have to be paid for with the entrepreneur’s own assets. The Inada
assumption for the utility function together with default not being possible force
entrepreneurs to guarantee that consumption is strictly positive for all realizations
of the productivity shock. Thus, when deciding the dimension of the firm an
entrepreneur may be constrained by the amount of accumulated assets which serve
as collateral to cover potential negative profits in case the entrepreneur is unlucky
enough and draws the lowest productivity shock. Since we assume that Q(z,z) > 0
for all z ∈ Z , all entrepreneurs will need to have some collateral when financing
investment projects.
After the labor income and profits are realized, agents decide on how much
to consume (c) and the amount of physical assets (a0) that they will take to next
period. This period’s shock z0 is also carried as next period’s signal for future
productivity shocks. The problem of an agent who enters the period with the pair
4 This could be motivated by the existence of limited commitment on the part
of borrowers in repaying the loans as in Cooley et al. [9].