credit market imperfection, inequality and capital accumulation

1

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

2

Outline

Motive

Research question

Model

Results

Credit Market Imperfection, Inequality and Capital Accumulation

3

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

4

Motive

Considering 56 countries over the period 2002-04, regressing

the entrepreneurship density on judicial efficiency:

Credit Market Imperfection, Inequality and Capital Accumulation

5

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

6

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

7

Motive

Regressing the GINI index on the Judicial Efficiency (JE) overthe period 1999-2001 for 42 countries.

Credit Market Imperfection, Inequality and Capital Accumulation

8

Research question

What is the impact of the credit market imperfectionson the relationship between inequality and capitalaccumulation ?

Credit Market Imperfection, Inequality and Capital Accumulation

9

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

10

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

11

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

12

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

13

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

14

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

15

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

16

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

17

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

18

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

19

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

20

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

21

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

22

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

23

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

24

Results

Credit Market Imperfection, Inequality and Capital Accumulation

25

Results