CHAPTER 10
Credit Market Imperfections: Credit Frictions,
Financial Crises, and Social Security
KEY IDEAS IN THIS CHAPTER
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
3. Asymmetric information and limited commitment are important for financial crises.
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.
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.
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
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.
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
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?
Chapter 10: Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security
OUTLINE
1. Credit Market Imperfections and Consumption
2. Asymmetric Information and the Financial Crisis
a) Banks
3. Limited Commitment and the Financial Crisis
a) Borrowers can default on their debts.
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
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
Instructor’s Manual for Macroeconomics, Fourth Canadian Edition
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
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
2. a) The present value of government spending can at most be
,
11
‘*
r
pH
NNy
r
G
G+
+=
+
+
where N is the number of consumers, and y* is the minimum income of any
b) A consumer’s collateral constraint can now be written
,‘)1( tpHrs −≤+−
Chapter 10: Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security
or
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
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.
The collateral constraint for the consumer is then
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,
Instructor’s Manual for Macroeconomics, Fourth Canadian Edition
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
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 nr>, as is depicted in
textbook Figure 10.7. A special circumstance applies to the cohort born in
5. An individual consumer chooses c and c’ to satisfy the lifetime budget constraint
”
(1 ) .
11
cyb
cs y
rr
+
++ =+
++
(1)
Chapter 10: Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security
Then, substituting for b in equation (1), using (2), and simplifying, we can determine
that, in equilibrium, c and c’ must also satisfy
First, consider the case where rn>. 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
Figure 10.2
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
6. a) Under this change in government policy, the government debt issued in period T
is
NbDT=,
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
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-