CONSUMPTION AND INVESTMENT DECISION

In the presence of an investment opportunity, a borrower decides whether to invest. I find that - depending on the borrower''s personal wealth and the presence of limited liability - the investment is not always undertaken, which leads to investment distortion. Furthermore, when the borrower has intertemporal consumption preference rather than aggregate consumption preference, the potential investment distortion problem is weakly exacerbated. The change of the borrower''s risk preference from constant absolute risk aversion to decreasing absolute risk aversion lowers the occurrence of the potential investment distortion as his personal wealth increases. Furthermore, when the borrower is privately informed about his personal wealth, the Revelation Principle applies and the naive contract which is derived from public information case is optimal.