Econ 313 lecture 7

Econ 313 lecture 7 - Lecture 7: Credit Readings: Todaro,...

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Lecture 7: Credit Readings: Todaro, Chapter 15
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Credit Imperfections of credit markets in developing countries: Adverse selection Moral hazard Empirical test for the presence of these phenomena Solution: Informal institutions of credit: microfinance
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Why is credit so important? Uses of credit: To finance investments in fixed capital: machines, factories… To finance investments in working capital (required for on-going production): seeds, pesticides, fertilizers… To finance investments in human capital: tuition fees… To smooth consumption: sickness, wedding…(≈insurance) Availability of credit is thus key to development On top of this, credit allocates funds efficiently : Available funds are used where the marginal return is the highest Moreover, credit is key to the poor: Lack of savings to weather schocks Seasonal activity (agriculture) Empirical literature shows strong positive effect of credit on development
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How does a perfect credit market  works? i: interest rate Supply of credit: S=s(i): increasing function of i? Demand of credit: D=d(i): ?
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How does a perfect credit market  works? i: interest rate Supply of credit: S=s(i): increasing function of i Demand of credit: D=d(i): decreasing function of i Interest rate i i* C* S D
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Is this what happens in reality? No, 3 anomalies: Anomaly 1: formal lenders (banks) only lend to the rich Anomaly 2: credit is rationed (demand is bigger than supply, observed interest rate is lower than i*) Anomaly 3: informal lenders exist, and lend to the poor
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Two violations of perfect markets Information asymmetries : the lender cannot observe: The choice of project The type of the borrower If the loan is indeed used to finance the mentioned project Limited responsibility : the borrowers are responsible only up to the amount of the collateral (guarantee) If the returns to a project are 0, and collateral was 0, the borrower repays 0 Two problems then occur: 1. Involuntary default 2. Voluntary default
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1. Involuntary default A borrower has 2 projects, P1 and P2, the lender cannot observe the choice Limited responsibility and initial wealth = 0 P1 and P2 necessitates 100, i=10% Returns to P1 = 120 for sure Returns to P2 = 230 with probability ½, 0 with probability ½ Which project is better in terms of maximization of social welfare? E(P1)=? E(P2)=?
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1. Involuntary default A borrower has 2 projects, P1 and P2, the lender cannot observe the choice Limited responsibility and initial wealth = 0 P1 and P2 necessitates 100, i=10% Returns to P1 = 120 for sure Returns to P2 = 230 with probability ½, 0 with probability ½ Which project is better in terms of maximization of social welfare? E(P1)=120
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Econ 313 lecture 7 - Lecture 7: Credit Readings: Todaro,...

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