Models Of Credit Markets Flashcards
(41 cards)
Intertemporal substitution model (why demand is high despite high interest
What is our maximum utility function
W₁ - income in period 1
W₂ - income in period 2
Can borrow (or lend) amount L at gross interest rate R in period 1.
Discount factor δ (for period 2)
Maximising utility for both periods:
Max u(c₁) + δu(c₂)
We get the Euler equation - and what does this mean
u’(c₁) = δRu’(c₂)
Add R to 2nd period as we have either borrowed or lent at rate R!
Consumption smoothing - Marginal utility constant
What does this become with credit constraints
w₁>=c₁ or L=0
u’(c₁) >= δRu’(c₂)
(Marginal utility today>marginal utility tomorrow)
So we are consuming less today!
Add possibility to invest amount I , with returns f(I) in period 2.
What is our c₁ and c₂ equations
C₁ = w₁ + L - I
(Consumption is out wage + amount we borrow - amount we invest)
C₂ = w₂ + f(I) - RL
(Consumption is our wage in p2 + returns from investment - loan cost
Sub into our utility maximisation (FC1)
Max u(c₁) + δu(c₂) becomes
Max u(w₁ + L - I) + δu(w₂ + f(I) - RL)
Solving the problem (F.O.C) with respect to investment what do we get
Intuition:
f’(I) = R
R (interest rate) determines optimal investment! (Think, keep adding £1 to invest as long as the return is greater than the interest rate, cos then better off saving in banks!)
From then we can use optimal investment I to find optimal loan L we should take out using c₁=w₁ +L - I
So with credit constraints what are the 2 equations (THEY ARE INEQUALITIES)
u’(c₁) >= δRu’(c₂)
f’(I)>=R (Return is higher than the interest rate which is good, but credit constraint so can’t access more loans)
Why is loan demand high despite R: (3)
Indiviudals may discount future heavily - δ is low offsetting high R
u’(c₁) >= δRu’(c₂)
Low δ means marginal utility in period 2 is low i.e consumption is high so need to borrow despite the high R
Or if w₂ is high. so consume more in future too c₂,so borrow more
If return f’(I) is high, so consume more too, so borrow more!!
What can explain low consumption today (c₁) but high marginal utility today?
Give an example
Transitory shocks
E.g health emergencies - will have a high marginal utility from spending
What has to be true for reality to fit the neoclassical model I.e why demand is high despite high R (4)
Poor may be myopic (do not think about tomorrow) ,
Or cannot reduce consumption due to subsistence constraints i.e need it to survive)
Or they are becoming non-poor very quickly
Or do not understand compound interest (hence why demand high still)
Or model is missing something
Thus what do lenders face? (2) (Hint: financial markets module!!)
Adverse selection - in choosing non-risky borrowers
Moral hazard - how they will spend the money is unknown
How can they lend effectively
Screening for safe/risky and monitoring actions.
And lenders differ in their ability to this (formal banks vs moneylenders) , and so does the cost (moneylenders typically can screen cheaper and less restrictions, SHOWN IN ENFORCEMENT MODEL NEXT!)
As a result they set interest rates high:
Lemons adverse selection problem
Higher interest rates mean safe borrowers drop out, so left with only riskier borrowers.
So what is the correlation between default and interest rate
Positive - more likely to default if interest rate is high
Karlan/Zinman (Karlan same person who tried paying off debt experiment, didn’t work, people still went back into debt - behavioural constraints etc)
Aim to distengle selection from incentive effect
Select in based on an offered interest rate, but incentives determines by contract interest rate.
50% were given a low offered interest rate. Who stuck with lower contract rate.
Other 50% given high offer rates, among them 50% given low contract rate anyways
How can we measure selection effects?
Default in high offer low contract - Default in low low
(to see purely effects from just selection choices as taken)
((DOUBLE CHECK THO!!)
How can we measure incentive effects?
Default in high offer high contract - default of high offer low contract (the 50% within the high offer rate that was given low rate!!)
see the effect of the incentive shifting since half were stilll given a low rate! we would expect higher default from the high high group!!
they added a dynamic rate too: All groups were promised future loans conditional on repayment
They were split into 2 groups
One group were offered future rates the same as current (contract) rate
Other were offered future rates higher than current rate
Regression
Defaulti =α+βoffer+βCcontract+βOdynamic+γXi +εi
Karlan/Zinman’s findings
Mild evidence for selection effects influencing default
Dynamic rate (moral hazard) - explains 22% of defaults. (people given the future rate equal to contract rate default less than the ones given the higher future rate!)
Huge caveat to these results that lessen the validity
Letters sent to former borrowers in good standing - we have pre-screened good borrowers, so reduced the selection effect
How do prices have selection and incentive effects
Selection - higher prices mean those who need it the most receive it. (Benefit of a free market - shows preferences)
Incentive - value more when paid for it.
When lenders screen, what do they look at/do? (3)
Where they live
Nature and scale of borrower’s business
Get references from others
(Imagine i do this on depop too when buying!)
What do they do for monitoring once they have screened and lent the money? (3)
Visit borrower
Check how loan is being used as intended, and if profitable
Chase loans if required
What is the problem with screen and monitoring
Costs time and money - and these expenses ARE FIXED i.e need basic info even for tiny loans.
Smaller the loan, larger the proportional screening cost, so higher the interest rate to compensate
