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ReviewNotesCreditFrictions_20100306

ReviewNotesCreditFrictions_20100306 - Econ 202(Winter 2010...

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Econ 202 (Winter 2010): review notes on credit frictions Carl Walsh March 6, 2010 1 Credit frictions 1.1 The market for lemons ° Akerlof showed how markets can fail if problems of asymmetric informa- tion become too severe. Example of used car market ° Assume there are good used cars and bad used cars (lemons). ° Assume everyone agrees a good used car is worth $10,000 and a lemon is worth $2,000. ° If buyers and sellers can tell which used car is good and which is a lemon, then two markets will co-exist. One for good used cars with an average price of $10,000 and one for lemons with an average price of $2,000. ° Now assume buyers cannot tell a good used car from a bad one. ° If the proportion of good used cars in the population of all used cars is 50%, then buyers would be willing to pay approximately $6,000 for a used car (this is its expected value °if buyers are risk averse, they would be willing to pay somewhat less than $6,000, but our focus is on asymmetric information, not risk, so assume everyone is risk neutral). ° Now assume the owners of used cars know whether their car is a lemon or not, but buyers cannot tell the di/erence. ° This is the asymmetric information. ° If the market price were $6,000, no owner of a good used car would want to sell (why accept $6,000 for a good used car worth $10,000), and only owners of lemons would want to sell their cars (since they much prefer $6,000 to a lemon worth only $2,000). 1
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° The lemons drive the good used cars o/ the market ° the price falls to $2,000 and only lemons are available on the market. ° Markets can fail to function if asymmetric information becomes too big of a problem. Financial market example ° Suppose a bank holds some mortgage backed securities °some are good, some are toxic. ° A potential buyer can±t tell which are good and which are toxic. ° If the market price re²ects some sort of average value of these securities, then the only ones a bank will want to sell are the toxic ones. ° Knowing (or fearing) that the only mortgage backed securities being of- fered for sale are the toxic ones, no one is willing to buy them. 1.2 The Diamond-Dybvig (1983) model and bank runs. 1.2.1 De±ning an illiquid asset ° Invest at time T = 0 . ° Value at T = 1 is r 1 . ° Value at T = 2 is r 2 . ° r 1 < r 2 . ° r 1 r 2 measures liquidity °the lower this is, the less liquid the asset. 1.2.2 Investors Investors do not know how long they will want to hold the asset ° uncertain horizon. At t = 0 , investor does not know whether he/she will want to consume (need to liquidate the asset) at T = 1 or T = 2 . This need to consume is private information °otherwise insurance markets could develop. Type 1 investors consume at time T = 1 . Type 1 investors consume at time T = 1 . At time T = 0 , investors do not know which type they will be, but they know they have a probability t if being type 1 and 1 ± t of being type 2 .
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