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Credit Markets, Limited Commitment, and Government Debt

  • Stephen Williamson

    (Washington University in St. Louis)

  • Francesca Carapella

    (Board of Governors of the Federal Reserv)

A model of credit and government debt with limited commitment is constructed, building on a Lagos-Wright construct. In the baseline equilibrium, global punishments support an efficient equilibrium in which government debt is neutral - there is Ricardian equivalence. In a symmetric equilibrium with individual punishments, trade in government debt essentially always serves to increase welfare by altering the incentive to default. In asymmetric equilibria, all borrowers are fundamentally identical, but some default in equilibrium, there is an adverse selection problem in a segment of the credit market, and good borrowers pay a default premium. Government debt, in addition to altering the incentive to default, serves to mitigate the adverse selection problem. Thus, government debt relaxes incentive constraints, working through an endogenous collateral effect. The model highlights the role of government debt in helping to solve the problem of a self-fulfilling breakdown in credit markets.

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File URL: https://economicdynamics.org/meetpapers/2012/paper_226.pdf
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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 226.

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Date of creation: 2012
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Handle: RePEc:red:sed012:226
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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