Chapter 9: Credit market failure

Question 1

Different interest rate for borrowers and lenders

Answer 1

• Credit markets are not perfect
• Charge a higher interest rate to borrowers (Red line)
• Same endowment point
• Lender has a lower interest rate

Question 2

Kinked budget constraint

Answer 2

Question 3

Optimal point for a lender

Answer 3

Endowment can happen in some cases

Question 4

Optimal point for a borrower

Answer 4

Endowment can happen in some cases

Question 5

Interest rate for borrowers increase

Answer 5

Becomes steeper and moves to the left

Increasing interest rate reduces the present value and lifetime wealth

Question 6

Why were interest rates increased for borrowers?

Answer 6

Recieve their funds back

Question 7

What was the impact of the increasing interest rate?

Answer 7

Made things worse and there was an increase in default

Question 8

Why does the Ricardian equivalnce not hold

Answer 8

• Movement of endowment point
• Points on the red line are available therefore tehy choose a new borrowing point
• Previosuly, in Ricardian, the consumer would save all the tax cut and consumption would remain unaffected, as the savings would be deciated towards the future tax increase.
• Greater incentive to take out loan and become a borrower

Question 9

Limited commitment and collateral

Answer 9

Lenders recieve assets as collateral. Collateral which is promised is taken away

Loan repayment -s(1+r) < (Collateral) pH

Question 10

Collateral and credit markets simple diagram

Answer 10

• Presence of collateral means a budget constraint is kinked
• Maximum consumption in the first period is private disposable income
• Borrower optimal position is to consume all the disposable income in the current period
• Collateral is something that takes long to sell therefore, it can only be sold in the future
• pH is the amount that can be added to the lifetime wealth when sold in the future, and the borrower is not going to be lent more, as this is the collateral
• Higher interest rate for lenders, so that banks are compensates the cost of making loans

Question 11

Budget constraint with collateral

Answer 11

Collateral constraint shows the maximum consumption in the current period

If the consumer was to borrow at the kink, then he or she would have a binding collateral constraint, borrowing up to the full amount that lenders will permit, and consuming future disposable income in the future period, with c ′ = y ′ - t ′ .

Question 12

The price of houses decreasing on the collateral constraint

Answer 12

• Decrease in housing prices
• Maximum amount that can be loaned decreases
• A constrained consumer cannot smooth the effects of the decrease in his or her wealth. Lower current consumption

Question 13

Random walk view of consumption

Answer 13

• No uncertainity about the future but in real life this is not true
• Basing analysis on expected changes in income
• Expected value of future income and therefore base decisions today on that

Question 14

Consumption vs expenditure

Answer 14

Retirement is confusing

• People consume less
• Calories remain the same but people have time to cook at home, which is much cheaper

Question 15

Pre-cautionary savings

Question 16

What is asymmetric information?

Answer 16

Asymmetric information refers to a situation where, in a particular market, some market participant knows more about his or her own characteristics than do other market participants. In the credit market context we examine, asymmetric information exists in that a particular borrower knows more about his or her own creditworthiness than do potential lenders. This credit market friction then leads to differences between the interest rates at which consumers can lend and borrow.

Question 17

Default premium

Answer 17

Loan interest rate reflects a default premium, which acts to compensate lendres for the fact that some borrowers default on loans

Lenders unable to distinguish between good and bad borrowers

Each good borrower must pay a default premium on a loan from the bank, which is equal to the difference r₂ - r₁(Interest rate for borrowers - Interest rate for lenders)

Question 18

What are interest rate speads?

Answer 18

Difference between interest rate on risky loans and safer loans

Question 19

What are credit market frictions?

Answer 19

Asymmetric information

Limited commitment

Question 20

What is limited commitment?

Answer 20

• Impossible for a market participant to commit in advance to some future action
• Given the choice, a rational borrower would choose to default on a loan if there were no penalty for doing so.

Question 21

Why do lenders post collateral?

Answer 21

Prevent lenders defaulting on loans, as if they do, then their collateral will be taken away

When collateral is posted as part of a credit contract, the borrower gives the lender the right to seize the collateral in the event that the borrower defaults on the loan.

Limited commitment can lead to situations where consumers are constrained in their borrowing by how much wealth they have that can serve as collateral— their ­ collateralizable wealth

If a consumer is collateral-constrained, then a change in the value of collateral will matter for how much they can consume in the present.

Question 22

Why is the endowment point often the optimal point?

Answer 22

Lending rate is too low

Borrowing rate is too high

Question 23

Asymetrical information: What is the profit for banks?

Answer 23

• L: Loan quantity
• r₁: Interest rate for lenders
• r₂: Interest rate for borrowers (Increases as a decreases)
• a: proportion of good borrowers (When it is equal to 1, then we have the standard credit market)
• Π: profit
• In equilibrium, profits is equal to 0
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Question 24

Increase in a

Answer 24

Budget contstraint moves to AEF, therefore borrowing is reduced and therefore consumption is reduced

Question 25

When was there a high interest rate spread?

Answer 25

Great depression

Financial crisis 2008-9

Question 26

What is the impact of assets being illiquid?

Answer 26

Hard to sell quickly

Question 27

Social security

Answer 27

• Thing used by the government to correct credit-market failure
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Question 28

Pay-as-you-go social security

Answer 28

• Taxes on the young are used to finance social security transfers to the old. Intergenerational transfers that may yield Pareto improvements.
• t=b/1+n
  
  • t: taxes
  • b: benefits of consumption goods, which are recieved in the future
  • n: population growth rate
• Consumer recieves y, when young and y+b, when old
• Income, when young: y-t=y-b/1+n
• Pay as you go social security begins after period T
• People born after T: Consumer is better off when they are older as they get benefits
• Better off if n>r and growth in we
• For pay-as-you-go social security to improve welfare for the consumer currently alive and those in future generations requires that the “rate of return” of the social security system be sufficiently high. This rate of return increases with the population growth rate n , as the population growth rate determines how large a tax burden there is for the young generation in paying social security benefits to the old. The smaller is this tax burden for each young person, the higher is the ratio of the social security benefit in old age to the tax paid to support social security when young, and this ratio is effectively the rate of return of the social security system. If n is larger than r , then the rate of return of the social security system is higher than the rate of return in the private credit market, and this is why social security increases welfare for everyone in this circumstance.

Question 29

Fully funded social security

Answer 29

• Fully funded social security is a program whereby the government invests the proceeds from social security taxes in the private credit market, with social security benefits determined by the payoff the government receives in the private credit market.
• Rate of return: r
• fully funded social security is effectively a forced savings program, and it matters only if the amount of social security saving is a binding constraint on consumers. That is, fully funded social security makes a difference only if the social security system mandates a higher level of saving than the consumer would choose in the absence of the program.
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Question 30

What are the issues with fully funded social security?

Answer 30

• they potentially allow public pension funds to be run inefficiently because of political interference. This problem occurs if the government manages the public pension fund rather than letting retirees manage their own retirement accounts. The existence of such a large quantity of assets in a public pension fund, seemingly at public disposal, often provides a tempting target for lawmakers and lobbyists.
• Moral hazard: Just as with banks, if retirement accounts were insured, then the managers of retirement accounts would tend to take on too much risk.