Publication: Credit and inflation under borrower’s lack of commitment
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2007-11
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Abstract
Here we investigate the existence of credit in a cash-in-advance economy where
there are complete markets but for the fact that agents cannot commit to repay their
debts. Defectors are banned from the credit market but they can use money balances for
saving purposes. Without uncertainty, deflation crowds out credit completely. The
equilibrium allocation, however, is efficient if the government deflates at the time
preference rate. Efficiency can also be restored with positive inflation. For any non
negative inflation rate below the optimal level, the volume of credit and the real interest
rate increase with inflation. Our results hold when idiosyncratic uncertainty is
introduced and households are sufficiently impatient but in one instance: efficiency
cannot be restored if the deflation rate is nearby the rate of time preference. Our
numerical examples suggest that the optimal inflation rate is not too large for reasonable
levels of patience and risk aversion. Finally, we present a framework where the use of
money arises endogenously and show that it is tantamount to our cash-in-advance
framework. Our results hold in this modified environment.
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Monetary policy, Existence of credit, Friedman rule, Self-enforcing debt, Risk sharing