Abstract
In this paper, I examine the constrained optimal pattern of capital flows between a lender and a borrower in an environment in which there are two impediments to forming contracts. The first impediment to contracting arises from the assumption that lenders cannot observe whether borrowers invest or consume borrowed funds. This assumption leads to a moral hazard problem in investment. The second impediment arises from the assumption that the borrower, as a sovereign nation, may choose to repudiate his debts. The optimal contract is shown to specify that the borrowing country experience a capital outflow when the worst realizations of national output occur. This seemingly perverse capital outflow forms a necessary part of the optimal solution to the moral hazard problem in investment.
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