Capital Accumulation in the Presence of Informal Credit Contracts: Does the Incentive Mechanism Work Better than Credit Rationing Under Asymmetric Information?
AbstractCredit markets with asymmetric information often prefer credit rationing as a profit maximizing device. This paper asks whether the presence of informal credit markets reduces the cost of credit rationing, that is, whether it can alleviate the impact of asymmetric information based on the available information. We used a dynamic general equilibrium model with heterogenous agents to assess this. Using Indian credit market data our study shows that the presence of informal credit market can reduce the cost of credit rationing by separating high risk firms from the low risk firms in the informal market. But even after this improvement, the steady state capital accumulation is still much lower as compared to incentive based market clearing rates. Through self revelation of each firm's type, based on the incentive mechanism, banks can diversify their risk by achieving a separating equilibrium in the loan market. The incentive mechanism helps banks to increase capital accumulation in the long run by charging lower rates and lending relatively higher amount to the less risky firms. Another important finding of this study is that self-revelation leads to very significant welfare improvement, as measured by consumptiuon equivalence.
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Bibliographic InfoPaper provided by University of Connecticut, Department of Economics in its series Working papers with number 2004-32.
Length: 39 pages
Date of creation: Oct 2004
Date of revision:
Note: I am really grateful to my advisors, Christian Zimmermann and Steven Ross for their guidance and valuable comments. Any types of errors in this paper are mine.
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More information through EDIRC
credit rationing; informal credit markets; self revelation mechanism;
Other versions of this item:
- basab dasgupta, 2005. "Capital Accumulation in the Presence of Informal Credit Contract: Does Incentive Mechanism Work Better than Credit Rationing Under Asymmetric Information?," Computing in Economics and Finance 2005 366, Society for Computational Economics.
- O16 - Economic Development, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
- O17 - Economic Development, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements
- E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-10-21 (All new papers)
- NEP-DGE-2004-10-21 (Dynamic General Equilibrium)
- NEP-MFD-2004-10-21 (Microfinance)
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