Credit Market Imperfections

• These notes explores credit market imperfections, focusing on asymmetric information and limited commitment, and their impact on financial stability and consumer behavior

Key Credit Market Imperfections

• Asymmetric information leads to lenders lacking complete borrower knowledge regarding future income and potential defaults
• Limited commitment exists when borrowers may choose not to repay loans if consequences can be avoided
• These imperfections result in higher borrowing rates and restricted credit access
• This can amplify economic downturns, potentially leading to financial crises

Moving Beyond Perfect Credit Markets

• Traditional models assume borrowers always repay debts and lenders possess perfect information
• A core question to consider: How do government policies affect credit market imperfections?
• The lecture explores realistic scenarios where these traditional assumptions don't hold

Impact of Asymmetric Information

• Lenders are unable to differentiate between "good" borrowers (who repay) and "bad" borrowers (who default)
• Borrowers possess information about their own type that banks do not

Bank's Profit Strategy

• Banks adjust interest rates to account for expected defaults, until profits reach zero
• The borrowing rate (rb) is higher than the lending rate (rl), compensating for risk: rb = 1 + rl/a - 1 - where a represents the proportion of good borrowers with future income

Amplification During Economic Downturns

• During economic downturns, defaults increase (a decreases), which leads to higher interest rates
• Higher interest rates reduce consumption and investment, exacerbating the economic decline

Limited Commitment and Strategic Defaulting

• Borrowers may strategically default if legal enforcement is weak or costly
• With limited commitment, default becomes an option
• Legal contracts are necessary to enforce

Collateral as a Mitigating Solution

• Collateral, (e.g., a house for a mortgage), acts as a repayment incentive
• Banks seize collateral if the borrower defaults, transferring ownership

Borrowing Limit

• The amount borrowed is constrained by the value of collateral: pH >-s(1 + rb) – where pH is the asset's value, s is the loan amount, and rb is the repayment rate

Economic Impact During Recessions

• Asset prices fall (p ↓) during recessions, reducing borrowing capacity
• Reduced borrowing leads to decreased consumption and investment, further deepening the economic crisis
• Different interest rates have important roles: asymmetric information and limited commitment

Higher Borrowing Costs

• Borrowers face higher interest rates than savers in order to compensate lenders for risk

Reduced Credit Availability

• The lack of access to loans for select individuals and firms is due to information gaps or insufficient collateral

Macroeconomic Instability

• Credit market imperfections worsen economic downturns and lead to deeper recessions

Government Policy Considerations

• Government policies (e.g., regulations, deposit insurance, credit registries) may mitigate credit market imperfections
• Other forms of collateral affect borrowing and the interaction of market frictions with monetary and fiscal policy exist

Asymmetric Information and Limited Commitment

• Asymmetric information and limited commitment drive up borrowing costs and restrict credit access which exacerbates financial crises
• Potential government intervention to mitigate inefficiencies and promote financial stability includes regulation, credit registries, or enforcement mechanisms

Imperfect Credit Market Implications

• Imperfect credit markets lead to divergence between borrowing (rb) and lending (rl) rates due to asymmetric information and limited commitment
• Banks charge higher borrowing rates to account for default risk and operational costs reflected in the "interest rate spread"

Consumer Behavior

• Consumers face different budget constraints as borrowers or lenders:
  • Borrowers: c + c' / (1 + rb) = y − t + (y' - t') / (1 + rb)
  • Lenders: c + c' / (1 + rl) = y − t + (y' – t') / (1 + rl)

Methodology for Solving

• Solve for consumption and savings as a borrower and check if the solution confirms borrower status; repeat as a lender and compare utility levels to determine the optimal choice

Ricardian Equivalence

• Ricardian Equivalence suggests tax timing shouldn't affect consumption, with consumers adjusting savings to offset government borrowing
• Borrowers face a higher interest rate (rb) than the government (rg), violating Ricardian Equivalence

Ricardian Equivalence: Scenario

• Government can borrow cheaper than consumers, allowing borrowers to save money
• When calculating two scenarios: t = 2, t' = 2 and t = 0, t' = 4.16, with y = 10, y' = 11, β = 0.9, rb = 0.12, rl = 0.08, rg = 0.08

Ricardian Equivalence: Impact

• The borrower borrows s = -0.44, consuming c = 8.44
• The lender lends s = 1.41, consuming c = 8.59
• Since consumption differs, Ricardian Equivalence does not hold

Credit Markets and Borrowing

• Failure of Ricardian Equivalence is due to imperfect credit markets where private borrowing is costlier than government borrowing

Borrowing and Savings Rates

• “Borrowing rates are typically higher than savings rates. Banks need to pay for real costs in order to provide services and make money on the interest rate spread.”

Policy Considerations

• Government borrowing can be welfare-enhancing if it allows consumers to access cheaper financing
• Imperfect markets distort consumption choices and may require potential regulatory interventions