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Corporate Governance over the Business Cycle

I propose a simple model to study the implications of corporate governance for the business cycle, based on the idea that managers tend to expand their firms beyond the profit maximizing size. What matters for aggregate dynamics is whether these deviations from profit maximization are more likely to happen in booms or in recessions. This, in turn, depends on how the relative costs and benefits of monitoring firms’ decisions change with the state of the economy.

I take the view that the comparative advantage of managers is to come up with new ideas to seize profit opportunities, and that scrutinizing managerial decisions is a time consuming process. Since it is particularly costly to miss a profit opportunity when the demand for the firm’s product is high, shareholders are more likely to leave discretionary authority in the hands of managers in good times than in bad times.

I study the implications of these governance conflicts in a standard dynamic macro model with imperfect competition in the goods markets. Managerial tendencies to increase investment, employment and output together with the proposition that shareholders leave more discretion to managers in good times implies that corporate governance conflicts amplify aggregate fluctuations. Quantitative simulations, based on the new empirical evidence presented in section 2, suggest that aggregate volatility would be 30% lower if all firms were always perfectly governed.

This research is related to the microeconomic literature on governance conflicts between managers and shareholders. Jensen (1986) emphasizes the idea that managers tend to expand their firms beyond the profit-maximizing size. On the macroeconomic side, I build on Blanchard and Kiyotaki (1987) and on Rotemberg and Woodford (1992)1 for the role of imperfect competition and counter-cyclical markups in explaining aggregate fluctuations. Chevalier and Scharfstein (1996) show how financial constraints can lead to counter-cyclical markups in a customer market model.

Corporate Governance over the Business Cycle