Chapter 10: Credit Market Imperfections: Credit

Frictions, Financial Crises, and Social Security

• Credit Market Imperfections: Asymmetric Information

& Limited Commitment
• Basic credit market imperfections problem for the
consumer with a kinked budget constraint
• Credit market frictions & failure of the Ricardian
Equivalence (RE)
• Asymmetric information & financial crises
• Social Security Programs (pay-as-you-go & fully funded
scheme).

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 Asymmetric Information:
A market friction
• Asymmetric information: One party lacks
crucial information about another party,
impacting decision-making.
ie. Would-be borrowers know more about their
characteristics than do lenders.
• We usually discuss this problem along two
fronts: adverse selection and moral hazard.
 Asymmetric Information:
Adverse Selection and Moral Hazard

• Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek a loan
3. Similar problems occur with insurance
where unhealthy people want their known
medical problems covered
 Asymmetric Information:
Adverse Selection and Moral Hazard

• Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to
engage in undesirable (immoral) activities
making it more likely that won't pay loan
back
3. Again, with insurance, people may engage
in risky activities only after being insured
Limited Commitment: Another market
friction

• Borrowers may choose to default. The lender can

overcome limited commitment with collateral.
• Borrowers need incentives not to default on their debts –
these incentives typically provided by collateral
requirements.
• Examples: House is collateral for a mortgage loan, car is
collateral for a car loan.

If the borrower cannot pay, the collateral gives the right to

the lender to sell those assets in order to cover what the
borrower couldn’t pay.
The borrower feels more obligated to repay the loan since
his/her assets are at stake
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Credit rationing, Credit exclusion and Credit
constrained individuals
https://www.youtube.com/watch?time_continue=123&v=0jddkoUl-5o
https://www.youtube.com/watch?v=n6LU20sAn9c

Typically the reason why the borrower needs a loan is that

he/she is not wealthy. As a result, he/she may be unable
to provide enough collateral and the lender refuses to offer
a loan or offers it on unfavourable terms.
• This is called credit rationing (the process by which
those with less wealth borrow on unfavourable terms,
compared to those with more wealth or are refused
loans entirely).
credit-excluded: borrowers whose limited wealth makes it
impossible to get a loan at any interest rate
credit-constrained: those who borrow, but only on
unfavourable terms
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Credit rationing, Credit exclusion and Credit
constrained individuals

• Adam Smith had credit rationing in

mind when he wrote:
• “Money, says the proverb, makes
money. When you have got a little it is
often easy to get more. The great
difficulty is to get that little.”
(An Inquiry into the Nature and Causes of
the Wealth of Nations, 1776)

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Credit Market Imperfections and
Consumption

• Assume that lenders can lend at a lower interest rate

(r1) than the one faced by borrowers (r2).
• The government borrows and lends at the interest rate
that lenders face (r1).
• This implies that Ricardian equivalence does not hold,
in general (since the lending and borrowing rate are not
equal any longer).

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Credit Market Imperfections &
Consumer’s budget constraints

• Current-period budget constraint: c+s=y-t

• Future-period budget constraint (different for lender

and borrower, given the different r)

• For a lender (s≥0): c’=y’-t’+s(1+r1)

• For a borrower (s≤0): c’=y’-t’+s(1+r2)

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Credit Market Imperfections &
Consumer’s lifetime budget constraint

• For a lender (if c≤y-t)

c' y' t'
c+ = y+ −t − = we1
1 + r1 1 + r1 1 + r1

• For a borrower (if c≥y-t)

c' y' t'

c+ = y+ −t − = we2
1 + r2 1 + r2 1 + r2

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Figure 10.1
A Consumer Facing Different Lending and Borrowing
Rates (borrowing rate, r2˃lending rate, r1)

AB: the lender’s budget

constraint
DF: the borrower’s budget
constraint
For a consumer that lends at a
lower r and borrows at a
higher r, the budget constraint
is: AEF
Many consumers choose E (as
r1 is too low & r2 is too high)

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Effects of a Tax Cut in current period for a Consumer with
Different Borrowing and Lending Rates

Tax cut in period 1: Δt˂0, so, in

period 2: - Δt(1+r1). This is the
consumer’s future tax liability
implied by the tax cut (assuming the
government pays r1 on its debt). E1
moves to E2 and the consumer
chooses E2, and c↑ (Different to the
RE result). Why? The tax cut is seen
as a low r loan. If borrowing was
possible at r1, G would be the choice
point.

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Effects of a Tax Cut with Credit Market
Imperfections

• So, here we supposed that the consumer is initially

credit constrained – that is, he or she saves zero. Also,
faces a higher borrowing rate than lending rate.
• For such a consumer, the entire tax cut will be spent
on current consumption.
• This is very different from the case with no credit
market imperfections, where the consumer will save the
entire tax cut to pay higher future taxes (RE).
• So, given frictions, there might be benefits arising from
government debt. People constrained by frictions can
be helped by current tax cuts.

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Asymmetric Information in Credit Markets

• Lending carried out through banks.

• Deposit rate at banks is r1, loan rate is r2.
• Fraction a of borrowers never defaults, fraction 1-a
always defaults. The bank cannot distinguish the good
borrowers from the bad ones.
• All good borrowers identical, borrow L.
• Bad borrowers mimic the good ones.
• Banks can minimise default risk by diversifying their
loan portfolio.

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Asymmetric Information – Deposit
Rate and Loan Rate

• Average profit () for the bank on each loan:

=L(1+r2)-L(1+r1) as bad borrowers (1- ) will pay 0
• In equilibrium,  = 0. This implies:
1 + r1
r2 = −1
a
Therefore, there is a default premium (r2 > r1)
when a < 1. The default premium increases as
a decreases. If a=1, there are only good borrowers, so,
no frictions and r1=r2.
As a →default premium (r2-r1)

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Asymmetric Information in the Credit Market and the
Effect of a Decrease in Creditworthy Borrowers
()

Initial budget constraint: AED

Now 
New budget constraint: AEF
For a borrower who chose a
point on ED before , both
c and borrowing 

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Effect of a Decrease in the Fraction
of Creditworthy Borrowers

• Default premium increases – even good borrowers face

higher loan rates.
• Budget constraint shifts in.
• Consumption falls for all borrowers.
• Matches observations from the current financial crisis –
increase in credit market uncertainty, reduction in
lending, decrease in consumption expenditures.

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Figure 10.4
Interest Rate Spread

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Limited Commitment and Credit Markets

• Borrowers need incentives not to default on their debts

– these incentives typically provided by collateral
requirements.
• Examples: House is collateral for a mortgage loan, car
is collateral for a car loan.

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Example

H=quantity of housing owned by consumer.

p=price of housing per unit, so,
pH=value of housing

• Assume: Housing is illiquid – can’t be sold in the

current period. However, it is possible to borrow
against housing wealth, with a collateral constraint.

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Consumer’s Constraints

Lifetime budget constraint:

c' y '−t '+ pH and c'
c+ = y −t + c+ = we
1+ r 1+ r 1+ r

Collateral constraint:
pH
c  y −t +
1+ r

c cannot be greater than y-t plus that amount borrowed by

pledging the future value of the house as collateral.

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Figure 10.5
Limited Commitment with a Collateral Constraint

Initial budget constraint: ABD

Price of collateral :
New budget constraint: FGH
No change in c’ BUT c by
the same amount as the
decrease in collateral

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The Relative Price of Housing in the United States

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Figure 10.7
Percentage Deviations from Trend in Aggregate
Consumption

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 Pension Funds

A pension fund is a fund established for

the payment of retirement benefits
Pension funds are financed by
contributions by the employee and / or
the employer
Many public pension funds are funded on
the pay-as-you-go basis. Also, fully
funded pension funds
Pay-as-you-go Social Security

• Taxes on the working population pay for social security

transfers to the retired each period.
• Suppose two generations alive at each date, young and
old.
• The young pay social security taxes (t), the old receive
social security benefits (b). So, current employees are
paying the pensions of the current retirees.

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Population Growth

• The population grows according to the following

equation. Each period, there are N’ young and N old
alive.
N ' = (1 + n) N
• Each consumer receives y when young & y’ when old
• G=0 in both periods
• Before date T, there is no social security and social
security taxes are 0 for both young & old in each
period.
• At date T, the pay-as-you go is introduced.

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The Government Balances Its Budget

• Total social security benefits must equal total taxes on

the young.
Nb = N ' t
• After date T, each old consumer gets benefits (b) of
units of consumption. These benefits for the old must
be financed by taxes on the young (t). Each young is
taxed an equal amount t.

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Relationship Between Taxes for the young and
Benefits for the old

• Solving for t the previous eq: t = Nb / N '

• And given that N ' = (1 + n) N

• Consumers that are old when the social security is

introduced in period T, gain as they get benefits but
don’t pay taxes when they are young.

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Figure 10.12
Pay-As-You-Go Social Security for Consumers
Who Are Old in Period T

Without Social security,

Budget constraint: AB, choice
point: H
With Social security: DF
At E2: y when young but y’+b
when old

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Pay-As-You-Go Social Security for Consumers
Born in Period T and Later

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Figure 10.13
Pay-As-You-Go Social Security for Consumers
Born in Period T and Later

If nr, the budget constraint

shifts out from AB to DF and
the consumer is better off.
If n<r, the budget constraint
would shift in and the
consumer would be worse off.

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Pay-as-you-go Social Security

• So, pay-as-you-go is beneficial only if the population

growth rate (n) exceeds the real interest rate (r).
• The interpretation is that the population growth rate is
the implied rate of return for an individual from the
social security system, so social security is only
worthwhile if the return exceeds what could be obtained
in private credit markets.

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 Problems with the Pay-as-you-go Social
Security

• The birthrate has declined tremendously since the mid-

1900s
• The baby boom generation is reaching retirement. This
causes a dramatic increase in the needed revenues to pay
for retirees. So, working population is shrinking while
the old generation has increased.
• People are living longer (advances in medicine, better
nutrition)

• So, contributions will no longer meet the benefit

outlays. This is a huge problem in many countries
(particularly, developed countries).

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Fully-Funded Social Security

• It is a program whereby the government invests the

proceeds from social security taxes in the private credit
market and social security benefits are determined by
the payoff the government gets in the private credit
market.
• Also, the government can allow the consumer to
choose in which assets to invest his social security
savings.
• Essentially, a mandated savings program where
assets are acquired by the young, with these assets sold
in retirement.

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Figure 10.14
Fully Funded Social Security When Mandated
Retirement Saving Is Binding

The fully funded social

security mandates a higher
level of savings than the
consumer would choose.
So, here the consumer must
choose F rather than D, and as
such, is worse off.

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 Problems of the fully funded system

• Public pension funds might be run inefficiently

because of political interference (socially responsible
investments might reduce benefits for the retirees)
• Might be subject to a moral hazard problem. If people
can choose where to invest, they might choose risky
assets…..
In such cases, these individuals will be most likely bailed
out by the government. Also, if retirement accounts were
insured (like bank deposits) then managers of the fund
would take higher risks (for higher return)
 Growth of Private Pension Funds. Why?

⁻ Problems/inefficiencies with Public

Pension funds
- Increase in income & wealth (more
money for long-term savings)
- Increase in Life expectancy (fin. needs
for longer periods)
- Tax benefits (Pensions are compensations
free of tax to the employee & employer’s
contributions are tax deductible)