ECN 600 Session.pat~ Type here to search Ch 10.pdf O CECN 600 Session._.pdf ~ em DELL Ct. the government would be called upon to insure you Chapter 10 Cordi Market Imperfections freda Fries insures the deposits in banks, The moral hazard gle n of deposit insurance by the government is well to ter 17. Just as with banks, if retirement account att premier the portion of a loan inter ates the besides for the pot rement accounts would tend to take on too much arrest rate spread: The gap es at which some files on risky loans and safer loans, or the highly risky investments pay off, so much the the they will be bailed out by the government. The eller isable wealth: Assets that can some class of inn whatvisuals can lend and boring itution that hor at borrows from a large set of ultimate lenders ther level of regulation would be needed to make s allen intermediary: A itance companies, and do not take on too much risk. The provision of put nealleads to a large set of ultimate borrowers. Examples are books, In accounts, and the necessary regulation required" Mural: An asset owned by the Borrower that the lender has the right to seize if the bornfast ght create enough costs that a pay-as you-go system chats on the loan- Mullage agreement: A short-term loan u it which security serves as ollieyou-go social security: A social security Hem in w benefits to the old are financed Pollives on the wo funded social security: A rity: A social security system in which the social security payments of odelled as a situation where the lending interest fully orking population are invested in assets, and the payoffs on there assets finance the sims it rate, Ricardian equivalence does not hold. A cur- thecity benefits of those people in old age. of taxes, with no effect on lifetime wealth, will securhazard: A situation in which insurance against a potential loss reduces the effort taken no effect on savings. by the insured to prevent the loss. netric information, under which lenders cannot would-be borrowers. In a credit market with good Questions for Review ate is less than the borrowing interest rate, reflect- rate. An increase in the fraction of bad borrow. What effects do credit market imperfections have on the interest rates faced by lenders and nium and reduces the quantity of lending borrowers? ted commitment-borrowers have an incen- , What are the effects of a tax cut on consumption and savings in the presence of credit mather rrowers the incentive to repay by requiring imperfections? Does Ricardian equivalence hold? n borrowers are collateral-constrained, a Does the existence of credit market imperfections imply that there is a useful role for gov reduces lending and consumption. emment tax policy? a credit market failure-the inability of 4. What are two sources of credit market imperfections? There are two types of government pro- 5. Explain how a default premium can arise, and what would cause it to increase. programs and fully funded programs, If the default premium increases, what is the effect on the consumption and savings of an ment benefits from taxes on the working he real interest rate is less than the rate individual consumer? For a borrower who is collateral-constrained, what happens when the value of collateraliz" able wealth falls? How does this matter for the financial crisis? d at worst constrains retirement sav- 8. Under what conditions will a pay-as-you-go social security system improve welfare for those irity can be justified if we think that currently alive and for all future generations? ial assistance to destitute senior 9. What are the effects of a fully funded social security system? act be less costly than fully funded 10. How does the government's ability to commit matter for social security programs? Problems 1. Suppose that there is a credit market imperfection due to asymmetric information, In the particular market, some market economy, a fraction b of consumers consists of lenders, who each receive an endowment an do other market participants of y units of the consumption good in the current period and 0 units in the future period: sible for a market partici mada wine textbook. work with seasonally adjusted data? in the 1970s and 1980s? Explain the significances332 Part 4 Savings, Investment, and Government Deficits A fraction (1 - b)a of consumers are good borrowers who each receive an endowment of 0 units in the current period and y units in the future period. Finally, a fraction (1-b)(1 -a) of consumers are bad borrowers who receive 0 units of endowment in the current and future periods. Banks cannot distinguish between good and bad borrowers. The government sets G = G' = 0, and each consumer is asked to pay a lump-sum tax of t in the current period and t' in the future period. The government also cannot distinguish between good and bad borrowers but can observe endowments. a. Write down the government's budget constraint, making sure to take account of who is able to pay their taxes and who does not. b. Suppose that the government decreases t and increases t' in such a way that the govern- ment budget constraint holds. Does this have any effect on each consumer's decision about how much to consume in each period and how much to save? Show, with the aid of diagrams. c. Does Ricardian equivalence hold in this economy? Explain why or why not. 2. Suppose there is a credit market imperfection due to limited commitment. As in the setup with collateralizable wealth we examined in this chapter, each consumer has a component of wealth that has value pi in the future period, that cannot be sold in the current period, and that can be pledged as collateral against loans. Suppose also that the government requires each consumer to pay a lump-sum tax t in the current period, and a tax t' in the future period. Also suppose that there is limited commitment with respect to taxation. That is, if a consumer refuses to pay his or her taxes, the government can seize the consumer's collater- alizable wealth but cannot confiscate income (the consumer's endowment). Assume that, if a consumer fails to pay off their debts to private lenders and also fails to pay their taxes, the government has to be paid first from the consumer's collateralizable wealth. a. Show how the limited commitment problem puts a limit on how much the government can spend in the current and future periods. b. Write down the consumer's collateral constraint, taking into account the limited commit- ment problem with respect to taxes. c. Now, suppose that the government reduces t and increases t' so that the government budget constraint continues to hold. What will be the effects on an individual consum- er's consumption in the present and the future? Does Ricardian equivalence hold in this economy? Explain why or why not. 3. Suppose that there is limited commitment in the credit market but lenders are uncertain about the value of collateral. Each consumer has a quantity of collateral H but from the point of view of lender, there is a probability a that the future period and n