Abstract
This paper studies a continuous-time hidden-action model with persistent observable shocks. In this model, I develop a method to characterize the optimal contract with history-dependent effort exertion and shirking decisions. Temporal shirking is always optimal after some histories as long as a positive persistent shock is expected. As a result, my model gives rise to a mechanism through which the moral hazard problem amplifies macroeconomic fluctuations. I also show the pattern of the agent’s utility adjustments with respect to persistent shocks and its implications for compensation design.
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