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A dynamic model of unsecured credit

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  • Daniel R. Sanches
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    Abstract

    The author studies the terms of credit in a competitive market in which sellers (lenders) are willing to repeatedly finance the purchases of buyers (borrowers) by engaging in a credit relationship. The key frictions are: (i) the lender is unable to observe the borrower's ability to repay a loan; (ii) the borrower cannot commit to any long-term contract; (iii) it is costly for the lender to contact a borrower and to walk away from a contract; and (iv) transactions within each credit relationship are not publicly observable. The lender's optimal contract has two key properties: delayed settlement and debt forgiveness. Asymmetric information gives rise to the property of delayed settlement, which is a contingency in which the lender allows the borrower to defer the repayment of his loan in exchange for more favorable terms of credit within the relationship. This property, together with the borrowers' lack of commitment, gives rise to debt forgiveness. When the borrower's participation constraint binds, the lender needs to "forgive" part of the borrower's debt to keep him in the relationship. Finally, the author studies the impact of the changes in the initial cost of lending on the terms of credit.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 11-2.

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    Date of creation: 2010
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    Handle: RePEc:fip:fedpwp:11-2

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    Keywords: Credit ; Contracts;

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    References

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    1. Irina A. Telyukova & Randall Wright, 2007. "A model of money and credit, with application to the credit card debt puzzle," Working Paper, Federal Reserve Bank of Cleveland 0711, Federal Reserve Bank of Cleveland.
    2. Aiyagari, S. Rao & Williamson, Stephen D., 2000. "Money and Dynamic Credit Arrangements with Private Information," Journal of Economic Theory, Elsevier, Elsevier, vol. 91(2), pages 248-279, April.
    3. Igor Livshits & James MacGee & Michèle Tertilt, 2011. "Costly Contracts and Consumer Credit," NBER Working Papers 17448, National Bureau of Economic Research, Inc.
    4. Guillaume Rocheteau & Randall Wright, 2005. "Money in Search Equilibrium, in Competitive Equilibrium, and in Competitive Search Equilibrium," Econometrica, Econometric Society, Econometric Society, vol. 73(1), pages 175-202, 01.
    5. Ethan Ligon & Jonathan P. Thomas & Tim Worrall, 2002. "Informal Insurance Arrangements with Limited Commitment: Theory and Evidence from Village Economies," Review of Economic Studies, Oxford University Press, Oxford University Press, vol. 69(1), pages 209-244.
    6. David Andolfatto, 2011. "The simple analytics of money and credit in a quasi-linear environment," Working Papers, Federal Reserve Bank of St. Louis 2011-038, Federal Reserve Bank of St. Louis.
    7. S. Rao Aiyagari & Stephen D. Williamson, 1999. "Credit in a Random Matching Model with Private Information," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(1), pages 36-64, January.
    8. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report, Federal Reserve Bank of Minneapolis 346, Federal Reserve Bank of Minneapolis.
    9. Chatterjee, Satyajit & Corbae, Dean & Ríos-Rull, José-Víctor, 2008. "A finite-life private-information theory of unsecured consumer debt," Journal of Economic Theory, Elsevier, Elsevier, vol. 142(1), pages 149-177, September.
    10. Koeppl, Thorsten & Monnet, Cyril & Temzelides, Ted, 2008. "A dynamic model of settlement," Journal of Economic Theory, Elsevier, Elsevier, vol. 142(1), pages 233-246, September.
    11. Thomas, Jonathan & Worrall, Tim, 1990. "Income fluctuation and asymmetric information: An example of a repeated principal-agent problem," Journal of Economic Theory, Elsevier, Elsevier, vol. 51(2), pages 367-390, August.
    12. Temzelides, Ted & Williamson, Stephen D., 2001. "Payments Systems Design in Deterministic and Private Information Environments," Journal of Economic Theory, Elsevier, Elsevier, vol. 99(1-2), pages 297-326, July.
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