We thank Guy Arie and Oscar Contreras for excellent research assistance. We especially thank Marina Halac

This paper studies a relational contracting model in which the agent is protected by a limited liability constraint. The agent’s effort is his private information and affects the output stochastically. We characterize the optimal relational contract and compare the dynamics of the relationship with that under the optimal long-term contract. Under the optimal relational contract, the relationship is less likely to survive, and the surviving relationship is less efficient. In addition, relationships always converge under the optimal long-term contract, but they can cycle under the optimal relational contract