In this dissertation, I further explore the role of the entrepreneurial sector in creating frictions in the economy. I examine the combined effect of private information and entrepreneurial risk aversion on the dynamics of a general equilibrium macroeconomic model. I analyze the impact of these frictions both at the micro level, in terms of the optimal contract between lenders and borrowers, and at the aggregate level within the context of a dynamic stochastic general equilibrium model.

This analysis uses a model similar to Bernanke, Gertler and Gilchrist (1999), in which the entrepreneur benefits from private information. Allowing for risk aversion among entrepreneurs modifies the optimal contract by introducing insurance and a risk premium that risk-averse entrepreneurs demand due to the stochastic nature of their investment returns: the private equity premium. This premium, in general equilibrium, may become a mechanism that magnifies and propagates the effects of shocks over time. The model predicts that economies with a relatively larger privately-held sector, all else equal, should be more volatile than economies with a relatively more important corporate sector.

I first examine a closed-economy framework, which isolates the role of the private equity premium as a mechanism that magnifies and propagates shocks over time. I then consider a small open economy and examine the role of exchange rates in affecting the private equity premium and the model's dynamics. I find that the exchange rate helps alleviate the propagating feature of the private equity premium. I also execute an exchange rate regime comparison where I show that the greater volatility associated with flexible exchange rate regimes adversely impacts the private equity premium and the supply of capital, amplifying the output response to shocks. I find that fixed exchange rate regimes could be preferable under less restrictive conditions than those commonly found in the literature.