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CHAPTER 10

Credit Market Imperfections: Credit Frictions,
Financial Crises, and Social Security
KEY IDEAS IN THIS CHAPTER
1.

The ideas of Chapter 9 are extended to cases where Ricardian equivalence may not
hold, and government debt can matter.

2. Two key credit market frictions are asymmetric information and limited commitment.
There is asymmetric information when participants in a particular market, or the two
parties to a particular exchange have different information. In this chapter we are
particularly interested in asymmetric information in credit markets – situations where
borrowers know more about their credit-worthiness than do lenders. Limited
commitment refers to situations where the party to a particular contract is not
committed to fulfilling the terms of that contract in the future. In loan contracts,
limited commitment means that the borrower always has the option of not repaying
the loan in the future. Lenders use collateral to offset the negative effects of limited
commitment.
3. Asymmetric information and limited commitment are important for financial crises.
During a financial crisis, there is more uncertainty in credit markets, which increases
interest rate spreads and reduces lending and consumption. As well, the value of
collateral falls, which also reduces lending and consumption.
4. There are two kinds of social security programs – pay-as-you-go and fully funded.
The rationale for social security is studied, as well as the potential economic benefits.

NEW IN THE FOURTH EDITION
1. This chapter has been broken off from Chapter 9, though most of the ideas were in the
third edition.
2. New: “Theory Confronts the Data: Asymmetric Information and Interest Rate
Spreads”
3. Charts and tables have been updated to reflect new data.

TEACHING GOALS
Credit market frictions and social security may not appear to be related issues, so it is
important to stress that this chapter extends the ideas of Chapter 9, by considering
instances where credit markets are not perfect. In a world with frictionless credit markets
(as considered in Chapter 9), there would be no financial crises or social security, for
example.
Copyright © 2013 Pearson Canada Inc.
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Fourth Canadian Edition The first key idea is that credit market frictions are typically reflected. social security can always be justified by appealing to commitment. without worrying about why that may be so. firms. and particularly the Canada Pension Plan (CPP). so long as the population grows at a sufficiently high rate. then it cannot make anyone better off. . or is there something deeper going on here. Students should be familiar with at least the existence of social security programs in the world. in a kinked budget constraint for the consumer. A discussion could start with the details of the CPP and how it is financed. Individuals cannot borrow all they would like to at market interest rates. The chapter begins by simply considering a kinked budget constraint. Why would private credit markets fail to the extent that social security might be welfare-enhancing? Copyright © 2013 Pearson Canada Inc. particularly the increase in interest rate spreads. Get the students to recall what was happening in credit markets in the world during the crisis. The financial crisis occurred recently. The model is a simplification of an overlapping generations model. Fully-funded social security is harder to justify economically. however. With limited commitment. the chapter considers social security systems – pay-as-you-go and fully-funded. in that people may not save adequately if they know that the government will always be willing to look after them old age. in our two-period model. asymmetric information is introduced. lending contracted. so students may remember some of the key details of what happened. What reasons could we think of for the existence of social security? Is this simply income redistribution. consumers. Then. Social security can be welfare-enhancing for everyone. which in this instance is explained by an increase in credit market uncertainty. Students should be encouraged to think about the implications of this for consumption expenditure. If this type of program is simply forced savings. borrowers sometimes have better information than do lenders about their credit-worthiness. collateral is used in lending contracts. Finally. as it removes choice. CLASSROOM DISCUSSION TOPICS Encourage students to think about the credit market frictions that exist in the world. where the consumer borrowers at a higher interest rate than he or she receives as a lender. we again obtain a kinked budget constraint. Recall that interest rate spreads increased. but now the budget constraint shifts in an interesting way with a decrease in the value of collateral.110 - . and governments sometimes default on their debts. to show how that leads to the kinked budget constraint. and this leads naturally to issues related to the financial crisis. we cannot borrow at the same interest rates at which we lend. and the model shows how this can be connected to a decrease in the demand for consumption goods. However. and there were credit market “freezes” in some segments of the market. but the idea is the same. The drop in housing prices in the United States was a key element of the financial crisis.Instructor’s Manual for Macroeconomics. so that these details can be related to the models studied in the chapter.

Credit Market Imperfections and Consumption a) Kinked budget constraint b) Tax cuts – Ricardian equivalence does not hold. b) To protect itself. the taxes paid by lenders and good borrowers. Limited Commitment and the Financial Crisis a) Borrowers can default on their debts. bad borrowers take out loans. respectively. good borrowers and lenders always pay their taxes.Chapter 10: Credit Market Imperfections: Credit Frictions. 4. . and Social Security a) Pay-as-you-go social security i) Population growth. ii) Problems with fully-funded social security TEXTBOOK QUESTION SOLUTIONS Problems 1. However. Intergenerational Redistribution. and they likewise pay their taxes. Financial Crises. and Social Security OUTLINE 1. the government’s present-value budget constraint is G+ G' N [a + (1 − a)b]t ' = Nt + 1+ r 1+ r Copyright © 2013 Pearson Canada Inc. constant interest rate ii) Welfare enhancing social security if population growth is high enough b) Fully funded social security i) Forced saving reduces welfare. In the current period.111 - . so as to mimic good borrowers. In this economy. 2. c) The value of collateral matters – construct kinked budget constraint. if t and t’ are. Ricardian Equivalence. Therefore. so as not to reveal themselves as bad. d) Effects of a decrease in the value of collateral. in the future period bad borrowers do not pay their taxes. a lender can require that the borrower post collateral. Asymmetric Information and the Financial Crisis a) Banks b) Good and bad borrowers c) Interest rate spread and kinked budget constraint d) Effects of an increase in the fraction of bad borrowers 3.

That is. Ricardian equivalence does not hold. 1+ r 1+ r 1+ r N 1+ r 1+ r and the lifetime wealth of each lender is we = y − t − t' 1 G' (1 − a)(1 − b) = y − (G + )− t' . then given the market interest rate. b) A consumer’s collateral constraint can now be written − s (1 + r ) ≤ pH − t ' . and y* is the minimum income of any pH consumer in this economy. Now. a) The present value of government spending can at most be G+ G' pH . and consumption. 2. all borrowers pay the interest rate r2 = 1+ r − a . and with what can be borrowed to pay taxes in the present. and given the interest rate on loans above. which is the same as the interest rate received by lenders. Then. We get this result because. = Ny * + N 1+ r 1+ r where N is the number of consumers. and this will cause a redistribution of wealth among consumers in the economy. . the higher are future taxes. the more bad borrowers have an opportunity to default on their taxes. r is the interest rate that the government pays on its debt. the lifetime wealth of good borrowers would then be we = ay t' ay 1 G' t ' (1 − a )b −t − = − (G + )− . However. Fourth Canadian Edition Here.Instructor’s Manual for Macroeconomics. if Ricardian equivalence holds. from the government’s budget constraint. 1+ r N 1+ r 1+ r Therefore. the additional income that the government can compensate is the minimum income that any consumer has in the present. Copyright © 2013 Pearson Canada Inc. and welfare will change if the government reduces current taxes and increases future taxes. if the government changes the timing of taxes this will leave everyone’s wealth unchanged. lifetime wealth of everyone cannot be invariant to changes in the timing of taxes. the real interest rate. holding constant government spending. a which includes a default premium. is the present value of the taxes that can 1+ r be paid by the consumer in the future. However.112 - . if all consumers pay the same taxes.

then r2 increases. then clearly Ricardian equivalence holds just as before. and savings would increase. consumption in the future period stays the same. This is because.3 of the chapter. if s > 0. the bad borrowers will all default. in the present and the future. then he or she faces the interest rate r2. b) If a decreases. In the figure. then Ricardian equivalence still holds. consumption in the current period falls.1. However. the budget constraint has two kinks. as they now have a higher future tax liability. a) There is a bank the pays an interest rate r1 on deposits and lends at the interest rate r2. so that the budget constraint shifts to ABFG in Figure 10. 3. and if s < 0. then the analysis would be identical to what was done for the asymmetric information model in Figure 10. there will be no effect. . Financial Crises. Thus. Copyright © 2013 Pearson Canada Inc.1. If the consumer had been a borrower for whom the collateral constraint does not bind. the future taxes reduce what anyone is willing to lend them. and the collateral constraint tightens. and Social Security or c ≤ y −t + pH − t ' 1+ r c) If the collateral constraint is not binding for any consumer. Fraction a of lenders are good borrowers who have collateral which will have a value pH in the future period. Consumption would decline in the current period. and the government can confiscate the collateral if they default. For this consumer. and savings increases. just as in the asymmetric information model. so consumption can remain unchanged. future consumption could increase or decrease (depending on income and substitution effects). Therefore. we show a consumer for whom the collateral constraint binds. if the collateral constraint binds for any consumers.113 - . This problem combines asymmetric information with limited commitment in the loan market. on the right-hand side of the collateral constraint above. all of the bad borrowers behave in the same way as the good borrowers. 1 + r2 As well. Just as in the asymmetric information model. For a lender. as depicted by ABDE in Figure 10. then a consumer faces the interest rate r1. changing the present value of taxes does not change the right-hand side of the constraint. and fraction 1-a are bad borrowers who have collateral that will be valueless. in equilibrium 1 + r1 r2 = −1 . If these consumers get a tax cut. Since there is limited commitment. Which can be rewritten as pH c ≤ y −t + . a The collateral constraint for the consumer is then −(1 + r2 ) s ≤ pH . even for constrained consumers.Chapter 10: Credit Market Imperfections: Credit Frictions.

1 4. However. the current old receive b in benefits and pay nothing. The current young receive b in benefits when they are old. An individual consumer chooses c and c’ to satisfy the lifetime budget constraint c' y '+ b = y+ (1) c(1 + s ) + . Therefore. they pay taxes to support two generations’ worth of benefits. it is identical to the pay-as-you-go system in the text. These individuals each receive a benefit per capita of b /(1 + r ) in present value terms. this borrowing and lending is represented in Figure 10. b) Once the program is running. This effect is also captured by the shift from BA to FD in the text’s Figure 10. both these generations unambiguously benefit from the program. The per capita share of their parents’ benefits is equal to b /(1 + n) . They pay taxes to retire the principal and interest on debt incurred in period T. In per capita terms. However. This program benefits a typical cohort as long as n > r . 5.6 in the text.6 as movements along the budget line. The per capita share of principal and interest on their grandparents’ benefits is equal to (1 + r )b /(1 + n)2 . a) When the program is first instituted. these amounts are bN/(1 + n) N = b /(1 + n) and (1 + r )bN/(1 + n) N = (1 + r )b /(1 + n) respectively. + (1 + n) (1 + n)2 This requirement is obviously more stringent than n > r . Fourth Canadian Edition Figure 10. Unless there is a change in the real interest rate. A special circumstance applies to the cohort born in period T + 1 . as is depicted in textbook Figure 10.7. The current young also lend bN to the government in period T and receive (1 + r )bN in principal and interest when they are old. . 1+ r 1+ r Copyright © 2013 Pearson Canada Inc. This generation can only benefit if: 1> (1 + r ) (1 + r )2 .Instructor’s Manual for Macroeconomics. there is no additional shift in the budget line.114 - .6. The effect on the current old is as in Figure 10.

2 Copyright © 2013 Pearson Canada Inc. the consumption bundle chosen by the consumer must satisfy (3). we can determine that. . so the social security program cannot make consumers better off if r > n . The consumer is better off with social security than without it. c and c’ must also satisfy y'  ( r − n) s  c ' c 1 + + = y+ . and H when the program is in place. or (1 + n) sc = b.2. the consumer is worse off with social security. it lies on AF in Figure 10. and the constraint (3) is given by AD.2. But with the social security program. taxes on the young must finance social security benefits for the old. again. consider the case where r > n .3. But point D is strictly preferred by the consumer to any point on AF. using (2). and the budget constraint without social security is AB.Chapter 10: Credit Market Imperfections: Credit Frictions.4. (2) Then. Then. consider the case where r < n . where. i.  1+ r  1+ r 1+ r  (3) First. without the social security program. where the consumer chooses G in the absence of the program. again. AF is constraint (1). the consumer chooses point D on budget constraint AB. Then. and simplifying. In the figure. so N ' sc = Nb. substituting for b in equation (1). and H with the social security program so that. It is possible that we could have a situation as in Figure 10. AD is constraint (3). in equilibrium. Financial Crises. the consumer’s budget constraint (1) is given by EF.e. while AB is the budget constraint without social security. Figure 10. in Figure 10. In this case the consumer chooses G without social security. However. it is also possible to have a situation as in Figure 10.115 - . and Social Security In equilibrium.

Instructor’s Manual for Macroeconomics. Fourth Canadian Edition Figure 10.116 - . the government debt issued in period T is DT = Nb .3 Figure 10. because the tax increases the price of current consumption relative to future consumption. 6. .4 The critical difference in this problem from the basic model is that the tax on the young is a distorting tax. Just as with lump-sum taxes. social security cannot improve things for everyone unless n > r. which results in a “friction” in the program. a) Under this change in government policy. but it is possible that n > r and social security cannot improve everyone’s welfare. There is a welfare loss simply from the way the tax is collected. Copyright © 2013 Pearson Canada Inc.

the lifetime wealth of any consumer born in periods T+1 on will now be we = y + y' n−r . the interest and principal on the debt will be Nb(1+r). we get t= b( r − n) > 0. Just as in the analysis of this chapter. Copyright © 2013 Pearson Canada Inc. the total tax paid by the old consumers in period T+1 is N ' t = Nb(1 + r ) − N ' b . and at worst constrains the savings of consumers and makes them worse off.Chapter 10: Credit Market Imperfections: Credit Frictions. whether the government gets rid of the social security system or not. in period T+1. Therefore. this at best has no effect. solving the above equation for t and simplifying. given this financing scheme. if a fullyfunded system is put in place. and the quantity of new debt issued will be N’b. it makes no difference. where t is the tax paid by each old consumer in period T+1. b) If the pay-as-you-go system were replaced by a fully-funded system. . Thus.117 - . 1+ n Therefore. and Social Security Then. since every period from T+1 on will look the same. this cannot make consumers any better off. Financial Crises. − 1+ r 1+ n But note that this is identical to the lifetime wealth these consumers would have if the pay-as-you-go social security system had stayed in place. Therefore.