Imperfect credit markets

Question 1

Whats the difference between perfect credit markets and imperfect credit markets?

Answer 1

1) Perfect credit markets = everyone pays its debts, people always says the truth
2) Imperfect credit markets, some dont pay their debts, someone lies.

Question 2

What is the difference between perfect credit markets and imperfect credit markets, with frictions?

Answer 2

Perfect credit markets - interest rates are the same for borrowers and lenders.

Credit markets with imperfections - interest rate is higher for borrowers than for lenders( this is to make sure they are compensated for someone not paying their debt)

Question 3

For a market with credit imperfections what is the budget constraint for the curent period and what is the difference between this an perfect credit markets?

Answer 3

y -t = c +s

the difference is rL < rB, if i am a borrower, i will have to pay a higher interest rate to lenders.

so borrowers pay a higher interest rate then what the lenders are receiving on their savings.

Question 4

Remember what are we not using?

Answer 4

We are not using money so you are saving and consuming bottles of whine.

Question 5

What is the future period budget constraint for a lender?

Answer 5

y’-t’ + (1+rL)s

( if you are a lender you receive rL which is low)

c’=y’-t’+(1+rL)s

Question 6

What is the future bugdet constraint if you are borrower?

Answer 6

y’-t’+(1+rB)S

c’= y’-t’+(1+rB)s

Question 7

How will tyrion intertemporal budget constraint look like if he is a lender?

Answer 7

Question 8

How does Tyrion intertemporal budget constraint look like if he is a borrower ?

Answer 8

Question 9

How will the 2 intertemporal budget constraints look like on a diagram, with the slope -(1+r)?

Answer 9

Remember if tyrion is a borrower, the interest rate is higher, meaning that, the slope is steeper as the slope is - (1+r)

Question 10

Correct the diagram, because we dont need all the

Answer 10

The intertemporal budget constraint that the consumers are facing, when they are in this imperfect credit market, where borrowers and lenders are charged different interest rates looks like this.

Question 11

So we know that borrowers and lenders have different slopes on our diagram now show their optimal choice?

Answer 11

draw this, yourself

Question 12

Why are credit markets not perfect?

Answer 12

Aysmmetric information

Limited commitment.

Question 13

What does Aysmmetric information mean?

Answer 13

People lie, people use their information at their own advantage

Question 14

What does Limited commitment mean?

Answer 14

People default on their debts

Question 15

Draw a diagram showing people not borrowing or not lending?

Answer 15

Question 16

What happens when the interest rate for borrowers increase

Answer 16

1) First of all the part of the intetemporal budget constraint that is affected is the one where he is a borrower, for lenders the interest rate didnt change, so no change in the intertemporal budget constraint for lenders.
2) this is different from last week as if affected both intercepts, when the interest rate increases the budget line for borrowers becomes steeper, still going thorught the endownment which dont change.

Question 17

What are causes and consequences of an increase of borrowing rate?

Answer 17

people lie about paying back their debt

As a lender i know that some people will not pay back the money and some people will, so what i would do to not lose money or make a profit is charge a higher interest rate, to all the people i lend the money to, so i get similar proportions of money than if i lend to everyone with a lower rate. The lender doesn’t know who is going to pay back (aysmmetric infotmation), hence the kink in the intertemporal budget constraint.

Question 18

Show the optimal choice of the borrower when there is an increase in borrowers rate and what happens to consumption and Aggregrate consumption?

Answer 18

I will have to reduce the amount i am borrowing, so consumption today will fall, or borrow less at a higher interest rate, so Aggregrate consumption decreases dramtiacally as a whole.

Question 19

So we have just talked about the 1st credit fricition which was Aysmmetric info and now we are talking about Limited commitment and collateral, what does this mean again?

Answer 19

Lenders(or banks) may not trust you at all

you may promise to pay your debt in the second period, but you dont.

Question 20

As lenders know there is a possibility that you might not pay their debt, what do they ask for the for you to do?

Answer 20

Post collateral: An asset ( house, car, security, govt bonds…) in case they dont pay the lender, they become owner of this asset.

Question 21

How will your intertemporal budget constraint look like if lenders dont trust you at all, and so you cant borrow?

Answer 21

You cant borrow anything in the current period, you can only consume your dispoable income.

Question 22

Lets say you wont to buy a house and you need a mortagage and you go to the bank, to ask money, but they dont truss you, so you need to put something down as collateral, which is what? and what are the 3 assumptions of this asset

Answer 22

You post the house H>0 house in square metres

Assumptions are :

1) Interest rate same for borrowers and lenders
2) house cannot be sold in the first period( it takes time to sell
3) If you sell iti for price p, for every square metre in the second period is pxh.

Question 23

How does posting collateral change the intertemporal budget constraint for the consumer

Answer 23

( so we assume interest rate for borrowers and lenders are the same, lets just say rL)

My lifetime wealth will be increased, as i can have more dispoable income in the second period by selling my house

Question 24

How will my endownment point and y intercept look if i post a house as collateral?

Answer 24

My endownment point will go up, vertically, and my y intercept will be higher

Question 25

How does lender react when borrowers ask about money for a mortagage and how much can they borrow?

Answer 25

When lenders post collateral, and ask money, they post the house and if they default,the bank takes the house

the lender comes up with the deal, that the repayment of the loan, must be less than the value of the house, thus it means you dont lose money as a lender.

Question 26

Show the expression that the repayment of the loan needs to be less than the value of the house?

Answer 26

c(consumption)( this must be greater than dispoable income) - dispoable income in the current period - the amount borrowed

The repayment is c-(y-t) times the (1+rL)

this is all less than value of the house.

Question 27

How can i reaggrange this equation to get that the current consumption by itself, what is it called?

Answer 27

the current consumption has to be lower than or equal to the dispable income + the value of the house / 1+rL. ( this is the value of rhe house in the second period calculated in terms of consumption goods in the first period ( so present value of the house )

This is called a collateral constraint

Question 28

Show the maxmium amount a consumer can reach on a diagram, when posting collateral?

Answer 28

Question 29

lets say my optimal choice was at endownment, and now i post collateral, how will my optimal choice look like now when previously i was consuming at dispoable income?

Answer 29

If my choice was at endownment, it is very likely, that now my choice would shift to the maximum i could borrow.

So i can reach an allocation i couldnt reach before, so i can consume more in the current period and nothing changes in the future period,. ( we are on a higher indifference curve)

Question 30

During the financial crisis, there was a dramatic drop in house prices, we want to show this on a diagram, but first what happens to the intertemporal budget constraint of consumer?

Answer 30

if i try to resale my house in the future the value of the house goes down, thus the intertemporal budget constraint moves to the left and down

Question 31

Show what a drop in house prices does our diagram,what does it mean for the bank and consumer?

Answer 31

The bank will lend you less money as the value of the house goes down, so consumer would reduce consumption in the current period dramatically, as he would not find a lender who will lend so much as before,

Preferences will have to change as we see from IC.