Abstract
We characterize Pareto efficient long term ‘relational’ lending contracts with one-sided lender commitment in a context where the borrower can accumulate wealth, has intertemporal consumption smoothing preferences, and the lender has some sanctioning power following default. We show the negative results of Bulow and Rogoff (1989) do not apply irrespective of the extent of sanctions, the borrower's preferences for smoothing, initial wealth or relative welfare weight. Borrowing, investment and wealth grow and converge to the first-best. Optimal allocations can be implemented by backloaded ‘progressive’ lending: a sequence of one period loans of growing size.
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