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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.

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Instructor’s Manual for Macroeconomics, Fourth Canadian Edition

The first key idea is that credit market frictions are typically reflected, in our two-period
model, in a kinked budget constraint for the consumer. The chapter begins by simply
considering a kinked budget constraint, where the consumer borrowers at a higher interest
rate than he or she receives as a lender, without worrying about why that may be so.
Then, asymmetric information is introduced, to show how that leads to the kinked budget
constraint, and this leads naturally to issues related to the financial crisis, particularly the
increase in interest rate spreads, which in this instance is explained by an increase in
credit market uncertainty.

With limited commitment, we again obtain a kinked budget constraint, but now the
budget constraint shifts in an interesting way with a decrease in the value of collateral.
The drop in housing prices in the United States was a key element of the financial crisis,
and the model shows how this can be connected to a decrease in the demand for
consumption goods.

Finally, the chapter considers social security systems – pay-as-you-go and fully-funded.
The model is a simplification of an overlapping generations model, but the idea is the
same. Social security can be welfare-enhancing for everyone, so long as the population
grows at a sufficiently high rate. Fully-funded social security is harder to justify
economically, however. If this type of program is simply forced savings, then it cannot
make anyone better off, as it removes choice. However, social security can always be
justified by appealing to commitment, in that people may not save adequately if they
know that the government will always be willing to look after them old age.

CLASSROOM DISCUSSION TOPICS

Encourage students to think about the credit market frictions that exist in the world.
Individuals cannot borrow all they would like to at market interest rates; we cannot
borrow at the same interest rates at which we lend; consumers, firms, and governments
sometimes default on their debts; collateral is used in lending contracts; borrowers
sometimes have better information than do lenders about their credit-worthiness.

The financial crisis occurred recently, so students may remember some of the key details
of what happened. Get the students to recall what was happening in credit markets in the
world during the crisis, so that these details can be related to the models studied in the
chapter. Recall that interest rate spreads increased, lending contracted, and there were
credit market “freezes” in some segments of the market. Students should be encouraged
to think about the implications of this for consumption expenditure.

Students should be familiar with at least the existence of social security programs in the
world, and particularly the Canada Pension Plan (CPP). A discussion could start with the
details of the CPP and how it is financed. What reasons could we think of for the
existence of social security? Is this simply income redistribution, or is there something
deeper going on here. Why would private credit markets fail to the extent that social
security might be welfare-enhancing?

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 Chapter 10: Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security
OUTLINE

1. Credit Market Imperfections and Consumption

a) Kinked budget constraint
b) Tax cuts – Ricardian equivalence does not hold.

2. 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. Limited Commitment and the Financial Crisis

a) Borrowers can default on their debts.
b) To protect itself, a lender can require that the borrower post collateral.
c) The value of collateral matters – construct kinked budget constraint.
d) Effects of a decrease in the value of collateral.

4. Ricardian Equivalence, Intergenerational Redistribution, and Social Security

a) Pay-as-you-go social security
i) Population growth, constant interest rate
ii) Welfare enhancing social security if population growth is high enough
b) Fully funded social security
i) Forced saving reduces welfare.
ii) Problems with fully-funded social security

TEXTBOOK QUESTION SOLUTIONS

Problems

1. In this economy, good borrowers and lenders always pay their taxes. In the current
period, bad borrowers take out loans, so as to mimic good borrowers, and they
likewise pay their taxes, so as not to reveal themselves as bad. However, in the future
period bad borrowers do not pay their taxes. Therefore, if t and t’ are, respectively,
the taxes paid by lenders and good borrowers, the government’s present-value budget
constraint is

G' N [a + (1 − a)b]t '

G+ = Nt +
1+ r 1+ r

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Here, r is the interest rate that the government pays on its debt, which is the same as
the interest rate received by lenders. However, all borrowers pay the interest rate

1+ r − a
r2 = ,
a

which includes a default premium. Now, if Ricardian equivalence holds, then given
the market interest rate, if the government changes the timing of taxes this will leave
everyone’s wealth unchanged. However, from the government’s budget constraint,
and given the interest rate on loans above, the lifetime wealth of good borrowers
would then be

ay t' ay 1 G' t ' (1 − a )b

we = −t − = − (G + )− ,
1+ r 1+ r 1+ r N 1+ r 1+ r

and the lifetime wealth of each lender is

t' 1 G' (1 − a)(1 − b)

we = y − t − = y − (G + )− t' .
1+ r N 1+ r 1+ r

Therefore, lifetime wealth of everyone cannot be invariant to changes in the timing of

taxes. Ricardian equivalence does not hold, and consumption, the real interest rate,
and welfare will change if the government reduces current taxes and increases future
taxes, holding constant government spending. We get this result because, the higher
are future taxes, the more bad borrowers have an opportunity to default on their taxes,
and this will cause a redistribution of wealth among consumers in the economy.

2. a) The present value of government spending can at most be

G' pH
G+ = Ny * + N ,
1+ r 1+ r

where N is the number of consumers, and y* is the minimum income of any

pH
consumer in this economy. That is, is the present value of the taxes that can
1+ r
be paid by the consumer in the future, and with what can be borrowed to pay taxes
in the present. Then, if all consumers pay the same taxes, the additional income
that the government can compensate is the minimum income that any consumer
has in the present.

b) A consumer’s collateral constraint can now be written

− s (1 + r ) ≤ pH − t ' ,

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 Chapter 10: Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security
or

pH − t '
c ≤ y −t +
1+ r

c) If the collateral constraint is not binding for any consumer, then clearly Ricardian
equivalence holds just as before. However, if the collateral constraint binds for
any consumers, then Ricardian equivalence still holds. This is because, on the
right-hand side of the collateral constraint above, changing the present value of
taxes does not change the right-hand side of the constraint, so consumption can
remain unchanged, in the present and the future, even for constrained consumers.
If these consumers get a tax cut, the future taxes reduce what anyone is willing to
lend them, as they now have a higher future tax liability, and the government can
confiscate the collateral if they default.

3. This problem combines asymmetric information with limited commitment in the loan
market. Fraction a of lenders are good borrowers who have collateral which will have
a value pH in the future period, and fraction 1-a are bad borrowers who have
collateral that will be valueless. Since there is limited commitment, the bad borrowers
will all default. Therefore, just as in the asymmetric information model, all of the bad
borrowers behave in the same way as the good borrowers.

a) There is a bank the pays an interest rate r1 on deposits and lends at the interest rate
r2. Just as in the asymmetric information model, in equilibrium
1 + r1
r2 = −1 .
a
The collateral constraint for the consumer is then
−(1 + r2 ) s ≤ pH ,
Which can be rewritten as
pH
c ≤ y −t + .
1 + r2
As well, if s > 0, then a consumer faces the interest rate r1, and if s < 0, then he or she
faces the interest rate r2. Thus, the budget constraint has two kinks, as depicted by ABDE
in Figure 10.1.

b) If a decreases, then r2 increases, and the collateral constraint tightens, so that the
budget constraint shifts to ABFG in Figure 10.1. In the figure, we show a
consumer for whom the collateral constraint binds. For this consumer,
consumption in the current period falls, consumption in the future period stays the
same, and savings increases. If the consumer had been a borrower for whom the
collateral constraint does not bind, then the analysis would be identical to what
was done for the asymmetric information model in Figure 10.3 of the chapter.
Consumption would decline in the current period, future consumption could
increase or decrease (depending on income and substitution effects), and savings
would increase. For a lender, there will be no effect.

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Figure 10.1

4. a) When the program is first instituted, the current old receive b in benefits and pay
nothing. The effect on the current old is as in Figure 10.6 in the text. The current
young receive b in benefits when they are old. This effect is also captured by the
shift from BA to FD in the text’s Figure 10.6. 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. In per capita terms, these amounts are bN/(1 + n) N = b /(1 + n)
and (1 + r )bN/(1 + n) N = (1 + r )b /(1 + n) respectively. However, this borrowing and
lending is represented in Figure 10.6 as movements along the budget line. Unless
there is a change in the real interest rate, there is no additional shift in the budget
line. Therefore, both these generations unambiguously benefit from the program.

b) Once the program is running, it is identical to the pay-as-you-go system in the

text. This program benefits a typical cohort as long as n > r , as is depicted in
textbook Figure 10.7. A special circumstance applies to the cohort born in
period T + 1 . These individuals each receive a benefit per capita of b /(1 + r ) in
present value terms. However, they pay taxes to support two generations’ worth
of benefits. They pay taxes to retire the principal and interest on debt incurred in
period T. The per capita share of principal and interest on their grandparents’
benefits is equal to (1 + r )b /(1 + n)2 . The per capita share of their parents’ benefits is
equal to b /(1 + n) . This generation can only benefit if:

(1 + r ) (1 + r )2
1> + .
(1 + n) (1 + n)2

This requirement is obviously more stringent than n > r .

5. An individual consumer chooses c and c’ to satisfy the lifetime budget constraint

c' y '+ b
c(1 + s ) + = y+ . (1)
1+ r 1+ r

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Chapter 10: Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security
In equilibrium, taxes on the young must finance social security benefits for the old, so
N ' sc = Nb,
or
(1 + n) sc = b. (2)

Then, substituting for b in equation (1), using (2), and simplifying, we can determine
that, in equilibrium, c and c’ must also satisfy

 ( r − n) s  c ' y'
c 1 +  + = y+ . (3)
 1+ r  1+ r 1+ r

First, consider the case where r > n . Then, in Figure 10.2, without the social security
program, the consumer chooses point D on budget constraint AB. But with the social
security program, the consumption bundle chosen by the consumer must satisfy (3),
i.e. it lies on AF in Figure 10.2. But point D is strictly preferred by the consumer to
any point on AF, so the social security program cannot make consumers better off if
r > n . Then, consider the case where r < n . It is possible that we could have a
situation as in Figure 10.3, where the consumer chooses G in the absence of the
program, and H with the social security program so that, again, the consumer is worse
off with social security. In the figure, the consumer’s budget constraint (1) is given by
EF, and the constraint (3) is given by AD, while AB is the budget constraint without
social security. However, it is also possible to have a situation as in Figure 10.4,
where, again, AF is constraint (1), AD is constraint (3), and the budget constraint
without social security is AB. In this case the consumer chooses G without social
security, and H when the program is in place. The consumer is better off with social
security than without it.

Figure 10.2

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Instructor’s Manual for Macroeconomics, Fourth Canadian Edition

Figure 10.3

Figure 10.4

The critical difference in this problem from the basic model is that the tax on the
young is a distorting tax, which results in a “friction” in the program. There is a
welfare loss simply from the way the tax is collected. Just as with lump-sum taxes,
social security cannot improve things for everyone unless n > r, but it is possible that
n > r and social security cannot improve everyone’s welfare, because the tax
increases the price of current consumption relative to future consumption.

6. a) Under this change in government policy, the government debt issued in period T
is

DT = Nb ,

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Chapter 10: Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security
Then, in period T+1, the interest and principal on the debt will be Nb(1+r), and
the quantity of new debt issued will be N’b. Therefore, the total tax paid by the
old consumers in period T+1 is

N ' t = Nb(1 + r ) − N ' b ,

where t is the tax paid by each old consumer in period T+1. Therefore, solving the
above equation for t and simplifying, we get

b( r − n)
t= > 0.
1+ n

Therefore, since every period from T+1 on will look the same, the lifetime wealth
of any consumer born in periods T+1 on will now be

y' n−r
we = y + − .
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. Thus, it makes no
difference, given this financing scheme, whether the government gets rid of the
social security system or not.

b) If the pay-as-you-go system were replaced by a fully-funded system, this cannot

make consumers any better off. Just as in the analysis of this chapter, if a fully-
funded system is put in place, this at best has no effect, and at worst constrains the
savings of consumers and makes them worse off.

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 HON. BEEKMAN WINTHROP
Copyright, Harris-Ewing, ’08.

THE SICILIAN AND CALABRIAN

EARTHQUAKE
“Messina and Reggio destroyed by an earthquake” flashed over
the wires and appeared in our press the last days of the year. The
terrible news, with its story of the fearful loss of life and property,
seemed too appalling to be true. The world, though stunned by its
magnitude, was yet to learn that no pen could describe the horrors of
a disaster unparalleled in modern history, and that only those who
saw the scene of devastation soon after the catastrophe have any
realization of its terrible results. As for those who lived through the
earthquake and escaped, the mental fear and physical agony they
had undergone left their minds dazed and blank. When some
realization of the truth dawned upon the world a wave of sympathy
was awakened everywhere. It is especially for such times of disaster
that the Red Cross has its being, and the call for help was
immediately issued from headquarters at Washington. The President
and Governors of States were notified that our National Society was
ready to receive and transmit the contributions our people were glad
to make for suffering Italy. President Roosevelt, in his cables to the
King of Italy, expressing his own and his countrymen’s sympathy,
stated that the “American Red Cross has issued an appeal for the
sufferers.” Many Governors of States issued proclamations, asking
that all contributions be sent through the American Red Cross. How
promptly and how generously, our people expressed their sympathy
in tangible shape is known everywhere. Glad were we in America to
do what we could to help our suffering fellow-men in beautiful and
well-loved Italy. Something of what the American Red Cross, our
national member of that greatest of all institutions of international
brotherhood, has been able to do with the contributions it has
received is told in this Bulletin by those who in Italy have helped to
administer the funds. In all of this work the Society has had the most
valuable and untiring assistance of Mr. Lloyd Griscom, the American
Ambassador at Rome. It cannot too strongly express its appreciation
of all that he has accomplished in the line of careful and prompt use
of the money it has sent. What our Red Cross has accomplished has
been done with a sincere desire to be of help, with a deep
appreciation of the complex and difficult problem Italy has had and
still has to face, and with the hope that the wounds of this beautiful
country, so recently devastated by this terrible calamity, may soon be
healed and the people re-established in a happy and prosperous life.
MAJ.-GEN. GEORGE W. DAVIS
Copyright, Harris-Ewing, ’08.
 ERNEST P. BICKNELL
Copyright, Harris-Ewing, ’08.

CONTRIBUTIONS TO THE ITALIAN

RED CROSS
Knowing that the Italian Red Cross was especially well organized
for carrying on hospital relief work, because of its field hospitals,
fourteen hospital trains and equipment for two ships’ hospitals,
besides an active personnel, the American Red Cross transmitted to
it through our Ambassador at Rome $320,000 to be applied to its
relief work in the earthquake district. The Italian Red Cross, in two
previous Calabrian earthquakes and at the time of the Vesuvian
eruption, maintained a number of hospitals and relief stations. At the
time of the latter disaster the American Red Cross received about
$12,000, which was transmitted to the Italian Red Cross. Later a
special report was made by this Society of the relief work it
performed at that time. A report of the relief operations in Southern
Italy will doubtless be issued sometime in the future, but this must
not be expected too soon, as experience has taught how long drawn
out is relief work after serious disasters. Baron Mayor des Planches,
the Italian Ambassador at Washington, in speaking of the Italian Red
Cross, said:
 CHARLES L. MAGEE.
Copyright, Harris-Ewing, ’08.

“As the representative of the Italian Government, I desire to

give the strongest indorsement of the Italian Red Cross, with
which the American Red Cross is in the most intimate
relation, and to say that my Government places absolute
confidence in this great national organization.”
 On January 4, the following cablegram was received from Count
Taverna:

“The Italian Red Cross tenders sincerest thanks to

American Red Cross for conspicuous contribution of
1,538,500 Italian lire, received through American Ambassador
in Rome, toward the relief of the distressed districts of
Reggio, Calabria and Messina, and begs to express its keen
appreciation of the feelings of solidarity and warm sympathy
with the stricken populations, which have prompted their
generous act.
“COUNT TAVERNA, President Italian Red Cross.”

Since this despatch was received further remittances have been

made, bringing the total of the American Red Cross contributions to
the Italian Red Cross up to $320,000.
 ROBERT W. DE FOREST

THE AMERICAN RED CROSS

ORPHANAGE
Hundreds of little
children were left
fatherless and
motherless amidst the
ruins of Messina and
Calabria. Scores of
them were even too
young to be able to give
any information in
regard to themselves or
their families. For years
these must be cared for,
and having been left
without property or
relatives, must be so
educated that, after
reaching mature years,
they will be able to
support themselves.
Queen Helena. Helpless childhood
appeals strongly to
everyone, and the Red
Cross, which after great calamities aims when the first temporary aid
is over, to rehabilitate and place again upon their feet the victims of
the disasters, was ready to accept the suggestion of the Italian
Government that some of the funds entrusted to its administration by
the American people should be devoted to the maintenance of an
agricultural colony in Sicily or Calabria for the care of a hundred or
more of the orphaned children. In national relief the American Red
Cross does not permit the use of its emergency funds for the
purpose of any permanent endowments, but in international relief it
believes it wisest to act under the suggestion of the American
diplomatic representative, the Government and relief committees in
the country where the disaster occurs. Therefore, when Mr. Griscom,
the Ambassador at Rome, after consulting with the Italian
Government, asked that such an agricultural orphanage colony be
maintained by a donation from the American Red Cross, the
suggestion was promptly complied with. Two hundred and fifty
thousand dollars are to be devoted to this purpose.
 REAR-AD. PRESLEY M. RIXEY
Copyright, Harris-Ewing, ’08.

The colony will be situated in Sicily or Calabria, and will consist of

model farms, where scientific agricultural instructions will be given by
agents of the Royal University of Agriculture. The Italian Government
will furnish the land, and the Italian National Relief, under the
patronage of Queen Helena will provide the buildings. It will be called
“The American Red Cross Orphanage,” and the American
Ambassador is to be an ex-officio member of its governing
committee. It is to be a lay institution, and not ecclesiastical. A yearly
budget of its expenses will be published, which must meet the
approval of the Minister of the Interior, who at present is also the
Prime Minister. A number of the poor women left widows and
dependent by the earthquake, and who in many cases also lost their
little children, will be given employment at this orphanage, and the
care of other little children will help to lift this sorrow from their
hearts. From these women the children will receive again much of
that mother-love and care of which this terrible disaster has robbed
them.
 SURG.-GEN. WALTER WYMAN
Copyright, Harris-Ewing, ’08.

Speaking of this orphanage, Mr. Griscom writes on February 19 to

the chairman of the Central Committee of the American Red Cross:
 “I can assure you that this generous gift of the American
Red Cross has made a profound impression in Italy. I made
the formal presentation to Her Majesty, the Queen, on the
16th instant, and Her Majesty was overcome with emotion
and for a moment at loss to express herself. Finally she made
a beautiful speech and poured forth her admiration for the
organization of the American Red Cross.”

Ambassador Griscom, under date of February 18, forwarded to the

State Department for transmission to the American Red Cross two
letters from the Countess Spaletti Rasponi, the President of the
Patronato Regina Elena, and from the Honorable Bruno Chimirri,
President of the “Comitato di Vigilanza,” respectively, expressing the
gratitude of the Committee and Council of the Patronato Regina
Elena for the gift of $250,000, for the establishment of the
Orphanage. The letters referred to follow:
 MAJ.-GEN. R. M. O’REILLY
Copyright, Harris-Ewing, ’08

“Excellency:
“The Council of the ‘Opera Nazionale di Patronato Regina
Elena,’ having known of the conspicuous offer of 1,300,000
lire made by the American National Red Cross in favor of the
children whom the recent earthquake has thrown into the
condition of orphans, has passed a vote of thanks to the
officers and to Your Excellency, to whose influential interest it
is due if so important a part of the funds collected in America
has been devoted to our institution.
“And I, interpreting the desire of the Council, warmly and
specially beg Your Excellency to kindly transmit to the
meritorious American Red Cross the expression of our
profound and heartfelt gratitude toward all the noble and great
American nation, not inferior to any other in all the
manifestations of human genius and solidarity.
“With the assurances of my highest consideration,
“The President,
(Signed) “COUNTESS SPALETTI RASPONI.”
 HON. ROBERT BACON
Copyright, Harris-Ewing, ’08

“Mr. Ambassador:
“I have the honor to offer you the warmest thanks of the
Committee and Council of the ‘Opera Nazionale di Patronato
Regina Elena’ for the generous offer which you have made on
behalf of the Calabrian and Sicilian orphans.
“I beg you to be good enough to be interpreter of our very
grateful sentiments to the American Red Cross, which has
completed, with its splendid gift, its relief work in Calabria and
Sicily.
“The Agricultural Colony, which will be named American
Red Cross Orphanage,’ will perpetuate the remembrance of
this charity, and will contribute to render continually more
close the ancient ties of sympathy and friendship which unite
Italy with your mighty Republic, ties which you called attention
to in your brilliant speech on the occasion of the centenary of
the great President Lincoln.
“Accept, Mr. Ambassador, the assurances of my high
consideration.
(Signed) “B. CHIMIRRI.
“To His Excellency,
“Hon. Lloyd C. Griscom,
“Ambassador of the United States of America, Rome.”
 MED. DIRECTOR J. C. WIRE
Copyright, Harris-Ewing, ’08

HOUSES FOR ITALY

Our own experiences
after serious disasters
in the United States
have taught us that in
nearly all of such cases
one of the most serious
problems to be met is
the providing of shelter
for the thousands—
sometimes hundreds of
thousands of victims.
Italy has had this same
serious problem to meet
after the late
unparalleled disaster in
Sicily and Calabria. The American Ambassador at Rome was
requested by the State Department to consult with the Italian
Government as to the best use to be made of the $500,000 left by
the Congressional appropriation of $800,000, after the supplies on
the Navy ships, Celtic and Culgoa, which were sent to the scene of
the disaster, had been paid for. The reply came in the nature of a
request that this fund be expended in the purchase and providing of
materials for houses. This suggestion has been admirably carried
out by the Navy Department, which has purchased and shipped, fully
prepared, materials for the immediate erection of 2,500 houses,
including window sashes, doors, etc., and the charter of four ships
for their transportation. Some eight expert carpenters and a large
number of tools have been sent on these vessels, that the erection
of these houses may go on promptly.