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Mahmoud Sami NABILEGI- Tunisia Polytechnic School
& IHEC Sousse
Credit Market Imperfection, Inequality
and Capital Accumulation
58ème Congrès de l’ AFSE11/09/2009
Credit Market Imperfection, Inequality and Capital Accumulation
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Outline
Motive
Research question
Model
Results
Credit Market Imperfection, Inequality and Capital Accumulation
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Motive
The banking system still dominates the financial system of
most developing countries.
The importance of the legal framework:
In case of borrower's default the bank often has the right to
seize collateral
In practice: the implementation of this right depends on the
judicial system efficiency
If the judicial system is weak, banks are willing to finance only
entrepreneurs providing sufficient collateral.
Credit Market Imperfection, Inequality and Capital Accumulation
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Motive
Considering 56 countries over the period 2002-04, regressing
the entrepreneurship density on judicial efficiency:
Credit Market Imperfection, Inequality and Capital Accumulation
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Motive
An economy may suffer from low entrepreneurship due to theweakness of its judicial system.
Possible explanation of this positive relationship between thejudicial efficiency and the entrepreneurship is credit rationing.
This credit rationing may accentuate the income inequality ina given economy.
Banerjee and Duflo (2005): "one person may start a large ormore technologically advanced firm because he has moneyand another may start a small and backward one because hedoes not".
Increasing income inequality
Credit Market Imperfection, Inequality and Capital Accumulation
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Motive
Possible explanation of this positive relationship between thejudicial efficiency and the entrepreneurship is credit rationing.
This credit rationing may accentuate the income inequality ina given economy.
Banerjee and Duflo (2005): "one person may start a large ormore technologically advanced firm because he has moneyand another may start a small and backward one because hedoes not".
Increasing income inequality
Credit Market Imperfection, Inequality and Capital Accumulation
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Motive
Regressing the GINI index on the Judicial Efficiency (JE) overthe period 1999-2001 for 42 countries.
Credit Market Imperfection, Inequality and Capital Accumulation
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Research question
What is the impact of the credit market imperfectionson the relationship between inequality and capitalaccumulation ?
Credit Market Imperfection, Inequality and Capital Accumulation
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Literature
Inequality is negatively associated with growth:Bertola (1993), Alesina and Rodrik (1994), Persson andTabellini (1994), Perotti (1996), …
Growth is an inverted U-- curve of inequality:Banerjee and Duflo (2005)
However, the effect of credit market imperfection on therelationship between inequality and capital accumulationwas rarely analyzed in a theoretical model.
Credit Market Imperfection, Inequality and Capital Accumulation
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Literature
Galor and Moav (2004) : income inequality -->development process in the presence of credit constraints.
Aghion and Bolton (1997) is the departure model of ourresearch.
They developed a theoretical model analyzing the relationbetween inequality and capital accumulation in presence ofa moral hazard problem.
Credit Market Imperfection, Inequality and Capital Accumulation
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Literature
Aghion and Bolton (1997) showed that the capitalaccumulation process begins by widening the inequalitiesbut reduces them in later stages.
Through which mechanism ?
-> "As more capital is accumulated there are more andmore funds available in the economy to finance a smallerand smaller pool of borrowers. Thus the equilibrium lendingterms are progressively shifted in favour of borrowers.“
Motivated by the stylized facts we expect that this resultmay change if another type of financial imperfection isconsidered.
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
Add new type of credit market imperfections in addition tothe moral hazard problem: costly contract enforcement(judicial inefficiency).
Contrarily to Aghion and Bolton (1997), enabling wealthyagents to undertake larger projects. The size of the projectis not normalized to one and wealthy agents could enlargetheir projects.
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
The economy is closed and contains a sequence of one-
period-lived overlapping generations.
Each generation is composed of a continuum of mass 1
agents indexed by i.
The only source of heterogeneity among agents is their
inherited wealth .
Each agent i is endowed with one unit of effort (labour)
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
An agent undertakes a project requiring a minimum fixed
investment generating an uncertain revenue ……
or invest his wealth in a bank.
The project could be self-financed or completed by an
external financing
Where and
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
Agents are risk-neutral and their utility depends only on
consumption and bequest .
where is the effort cost.
An agent divides the income he receives between
consumption and bequest.
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
Initial distribution of wealth at date t=0 a proportion π of
the young agents has a low inherited wealth w₀<w and
constitutes the class i=l. .
A proportion 1-π has a high inherited wealth w₀ <w₀<w
and constitutes the class .
An agent of class i=l,h with an initial wealth {t}^{i}≥w
could self-finance his project. He may have an incentive to
ask for a bank loan in order to enlarge it.
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
Even the project succeeds, an agent may have an
incentive to default on the loan.
the bank seizes a fraction of the output.
The unseized fraction corresponds to an enforcing
repayment cost (the efficiency's level of the judicial
system).
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
An optimal investment contract between the agent and the
bank specifies the repayment schedule for the class i
agent asking for an external financing
In order to prevent the borrower's default, the repayment
….. should be at most equal to the default's cost ……..
The maximum amount of loan the bank grants to the agent
of class i is
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
Given the unit repayment rate the borrower chooses the
effort to supply and the amount of loan in order to
maximize his expected revenue net of both repayment and
effort costs
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
Given that:
The economy comprises at each date t a continuum of
agents belonging to the two classes,
The random returns of the project are iid
The proportion of successful projects is for the class i.
The return of the banks from loans granted to the agents of
class i is deterministic and is given by .
Assuming a competitive banking system
Credit Market Imperfection, Inequality and Capital Accumulation
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Model
Only agents with an initial endowment prefer strictly
becoming depositors.
Those with prefer becoming entrepreneurs.
The threshold is determined by the indifference
condition
Credit Market Imperfection, Inequality and Capital Accumulation
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Results
The wealth inequality widens between the two classes of
agents in a first stage of development. Outside, it remains
constant or widens depending on the deposit interest rate
ceiling.
Why ?
Without a ceiling on the deposit interest rate there exists
always a value of such that making the
low inheriting agents always preferring depositing and the
high inheriting agent preferring undertaking a project
Credit Market Imperfection, Inequality and Capital Accumulation
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Results
Numerical simulations of the judicial efficiency effect on the
wealth inequality (measured by the GINI index) in the case of
an interest rate ceiling
An increase of the judicial efficiency:
reduces the speed of convergence of the GINI index to its
long run level.
decreases the long run level of wealth inequality.
Credit Market Imperfection, Inequality and Capital Accumulation
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Results
Credit Market Imperfection, Inequality and Capital Accumulation
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Results