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The authors analyze repeated moral hazard with discounting in a competitive credit market with risk neutrality. Even without learning or risk aversion, long-term bank-borrower relationships are welfare enhancing. The main result is that the borrower obtains an infinite sequence of unsecured loans at below spot market cost following the first good project realization. This contract produces first-best action choices. Prior to this stage, the borrower gets secured loans with above-market borrowing cost. The optimal contract thus displays a selective memory feature, taking only one of two forms at any given point in time, depending on prior history. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.
Boot et al. (1994) studied this question.