This paper proposes a flexible-price theory of the role of money in an economy with incomplete idiosyncratic risk sharing. When the risk premium goes up, money provides a safe store of value that prevents interest rates from falling, reducing investment. Investment is too high during booms when risk is low, and too low during slumps when risk is high. Monetary policy cannot correct this: money is superneutral and Ricardian equivalence holds. The optimal allocation requires the Friedman rule and a tax/subsidy on capital. The real effects of money survive even in the cashless limit. (JEL E32, E41, E43, E44, E52)

I characterize the optimal financial regulation policy in an economy where financial intermediaries trade capital assets on behalf of households, but must retain an equity stake to align incentives. Financial regulation is necessary because intermediaries cannot be excluded from privately trading in capital markets. They don’t internalize that high asset prices force everyone to bear more risk. The socially optimal allocation can be implemented with a tax on asset holdings. I derive a sufficient statistic for the externality and use market data on leverage and volatility of intermediaries’ equity to measure it. (JEL D82, G01, G12, G20, G31, H25)

This paper investigates the origin and propagation of balance sheet recessions. I first show that in standard models driven by TFP shocks, the balance sheet channel disappears when agents can write contracts on the aggregate state of the economy. Optimal contracts sever the link between leverage and aggregate risk sharing, eliminating the concentration of aggregate risk that drives balance sheet recessions. I then show that uncertainty shocks can help explain this concentration of aggregate risk and drive balance sheet recessions, even with contracts on aggregate shocks. The mechanism is quantitatively important, and I explore implications for financial regulation.

We characterize optimal asset management contracts in a classic portfolio‐investment setting. When the agent has access to hidden savings, his incentives to misbehave depend on his precautionary saving motive. The contract dynamically distorts the agent's access to capital to manipulate his precautionary saving motive and reduce incentives for misbehavior. We provide a sufficient condition for the validity of the first‐order approach, which holds in the optimal contract: global incentive compatibility is ensured if the agent's precautionary saving motive weakens after bad outcomes. We extend our results to incorporate market risk, hidden investment, and renegotiation.

Abstract We develop a simple flexible-price model of business cycles driven by spikes in risk premiums. Aggregate shocks increase firms’ uninsurable idiosyncratic risk and raise risk premiums. We show that risk shocks can create quantitatively plausible recessions, with contractions in employment, consumption, and investment. Business cycles are inefficient—output, employment, and consumption fall too much during recessions, compared to the constrained-efficient allocation. Optimal policy involves stimulating employment and consumption during recessions.