ECO3020F - Macro Chapter 10

Asymmetric Information

One party lacks crucial information about another party, impacting decision-making

Adverse Selection

Before a transaction occurs. Potential borrowers likely to produce adverse outcomes are ones most likely to seek a loan. Similar problems occur with insurance where unhealthy people want their known medical problems covered.

Moral Hazard

After a transaction occurs. hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that they won't pay loan back. Again, with insurance, people may engage in risky activities only after being insured.

Collateral

Borrowers need incentives not to default on their debts.

Effects of Collateral

Gives the right to the lender to sell those assets in order to cover what the borrower couldn't pay. Borrower feels more obligated to pay

Reason for a loan

Borrower is not wealthy enough to pay for the full asset/

Credit Rationing

Process by which those with less wealth borrow on unfavourable terms, compared to those with more wealth are refused entirely.

Credit-excluded

Borrowers whose limited wealth makes it impossible to get a loan at any interest rate.

Credit-constrained

Those who borrow, but only on unfavourable terms.

Current-period budget constraint

C + S = Y -T

Future-period lender constraint

C' = Y' - T' + S(1+r1)

Future-period borrower constraint

C' = Y' - T' + S(1+r2)

Effect of a Decrease in the Fraction of Creditworthy Borrowers

Default premium Increases - even good borrowers face higher loan rates.

Budget constraint Shifts in.

Consumption falls for all borrowers

Matches "Increase in credit market uncertainty, reduction in lending, decrease in consumption expenditures.

Pension Fund

A fund established for the payment of retirement benefits.

Financed by contributions by the employee and/or employer.

Pay-as-you-go Social Security

Taxes on the working population pays for social security transfers to the retired for each period.

Social Security Requirement

The population growth rate is the implied rate of return for an individual from the social security system. Hence Social security is only worthwhile if the return exceeds what could be obtained in private credit markets.

Problems with the Pay-as-you-go Social Security

If the birthrate decreases while people live longer, the contributions will no longer meet the benefit outlays.

Fully-Funded Social Security

A program whereby the government invests the proceeds form social security taxes in the private credit market and social security benefits are determined by the payoff the government gets in the private credit market.

Fully-Funded Social Security 2

Government can allow the consumer to choose in which assets to invest his social security savings.

Essentially, a mandated savings program where assets are acquired by the young, with these assets sold in retirement.

Fully-Funded Social Security 3

Mandates a higher level of savings than the consumer would choose. Consumer is hence worse off.

Problems of The Fully-Funded Systems

Public pension funds might be run inefficiently because of political interference (socially responsible investments might reduce benefits for the retirees)

Problems of The Fully-Funded Systems 2

Might be subject to a moral hazard problem. If people can choose where to invest, they might choose risky assets. These people will likely be bailed out by the government.

Growth of Private Pension Funds

Problems/ Inefficiencies with Public Pension Funds.

Increase in income and wealth (more money for long-term savings)

Increase in life expectancy (financial needs for longer periods)

Tax benefits (Pensions are compensations free of tax to the employee and employer's contributions are deductible)