Liquidity preference, costly state verification, and optimal financial intermediation

Includes bibliographical references (p. 26-27)

Computing General Equilibrium Models with Occupational Choice and Financial Frictions

This paper establishes the existence of a stationary equilibrium and a procedure to compute solutions to a class of dynamic general equilibrium models with two important features. First, occupational choice is determined endogenously as a function of heterogeneous agent type, which is defined by an agent's managerial ability and capital bequest. Heterogeneous ability is exogenous and independent across generations. In contrast, bequests link generations and the distribution of bequests evolves endogenously. Second, there is a financial market for capital loans with a deadweight intermediation cost and a repayment incentive constraint. The incentive constraint induces a non-convexity. The paper proves that the competitive equilibrium can be characterized by the bequest distribution and factor prices, and uses the monotone mixing condition to ensure that the stationary bequest distribution that arises from the agent's optimal behavior across generations exists and is unique. The paper next constructs a direct, non-parametric approach to compute the stationary solution. The method reduces the domain of the policy function, thus reducing the computational complexity of the problem.Existence; Computation; Dynamic general equilibrium; Non-convexity

Credit rationing by loan size in commercial loan markets

The authors present a theoretical model in which a profit-maximizing lender may ration credit to businesses by restricting loan size. Such credit rationing occurs despite the absence of differences across borrowers in default risk or loan administration costs. Moreover, the model predicts an interest rate-loan size pattern that matches that observed in U.S. commercial loan markets.Credit ; Bank loans

The Effect of Financial Repression & Enforcement on Entrepreneurship and Economic Development

This paper studies the effect of financial repression and contract enforcement on entrepreneurship and economic development. We construct and solve a general equilibrium model with heterogeneous agents, occupational choice and two Financial frictions: intermediation costs and financial contract enforcement. Occupational choice and firm size are determined endogenously, and depend on agent type (wealth and ability) and the credit market frictions. The model shows that differences across countries in intermediation costs and enforcement generate differences in occupational choice, firm size, credit, output and inequality. Counterfactual experiments are performed for Latin American, European, transition and high growth Asian countries. We use empirical estimates of each country's financial frictions, and United States values for all other parameters. The results allow us to isolate the quantitative effect of these financial frictions in explaining the performance gap between each country and the United States. The results depend critically on whether a general equilibrium factor price effect is operative, which in turn depends on whether financial markets are open or closed. This yields a positive policy prescription: If the goal is to maximize steady-state efficiency, financial reforms should be accompanied by measures to increase financial capital mobility.Financial frictions; Financial reform; Occupational choice; Development

Risky Banking: Optimal Loan Quantity and Portfolio Quality Choices

In this paper we construct a model of a "risky bank". The bank faces excess demand in the loan market, can sort loan applicants by an observable measure of quality, and faces a small but positive probability of default on its loan portfolio. The bank uses two policies to allocate credit: - Tighten restrictions on loan quality - Limit the number of loans of a given quality We show that the level of default risk and other structural conditions have important e®ects on the market for loanable funds and the bank's optimal policies (loan rates, deposit rates, and lending standards). The structural conditions that we examine are monitoring costs, returns on alternative investments, firms' minimum funding requirements, and the level of the reserve requirement. The model provides insight into several stylized facts observed in loan markets, especially in developing countries.Facultad de Ciencias Económica

Risky Banking: Optimal Loan Quantity and Portfolio Quality Choices

In this paper we construct a model of a "risky bank". The bank faces excess demand in the loan market, can sort loan applicants by an observable measure of quality, and faces a small but positive probability of default on its loan portfolio. The bank uses two policies to allocate credit: - Tighten restrictions on loan quality - Limit the number of loans of a given quality We show that the level of default risk and other structural conditions have important e®ects on the market for loanable funds and the bank's optimal policies (loan rates, deposit rates, and lending standards). The structural conditions that we examine are monitoring costs, returns on alternative investments, firms' minimum funding requirements, and the level of the reserve requirement. The model provides insight into several stylized facts observed in loan markets, especially in developing countries.Facultad de Ciencias Económica

Computing General Equilibrium Models with Occupational Choice and Financial Frictions

This paper establishes the existence of a stationary equilibrium and a procedure to compute solutions to a class of dynamic general equilibrium models with two important features. First, occupational choice is determined endogenously as a function of heterogeneous agent type, which is defined by an agent’s managerial ability and capital bequest. Heterogeneous ability is exogenous and independent across generations. In contrast, bequests link generations and the distribution of bequests evolves endogenously. Second, there is a financial market for capital loans with a deadweight intermediation cost and a repayment incentive constraint. The incentive constraint induces a non convexity. The paper proves that the competitive equilibrium can be characterized by the bequest distribution and factor prices, and uses the monotone mixing condition to ensure that the stationary bequest distribution that arises from the agent’s optimal behavior across generations exists and is unique. The paper next constructs a direct, non-parametric approach to compute the stationary solution. The method reduces the domain of the policy function, thus reducing the computational complexity of the problem.

Intermediation costs, investor protection and economic development

This paper studies the effect of financial repression and contract enforcement on entrepreneurship and economic development. We construct and solve a general equilibrium model with heterogeneous agents, occupational choice and two financial frictions: intermediation costs and financial contract enforcement. Occupational choice and firm size are determined endogenously, and depend on agent type (wealth and ability) and credit market frictions. The model shows that differences across countries in intermediation costs and enforcement generate differences in occupational choice, firm size, credit, output and inequality. Counterfactual experiments are performed for Latin American, European, transition and high growth Asian countries. We use empirical estimates of each country's financial frictions, and United States values for all other parameters. The results allow us to isolate the quantitative effect of these financial frictions in explaining the performance gap between each country and the United States. The results depend critically on whether a general equilibrium factor price effect is operative.

Discount factors and thresholds: Foreign investment when enforcement is imperfect

We consider a model that provides insight into the well-known Folk theorem in economics that when the discount factor beta is sufficiently close to 1, expropriation will never occur. Although this Folk theorem is true in our model, our perspective is different. The discount factor beta often is described as a "deep structural parameter" that is difficult to alter at a point in time. In contrast, we analyze the determinants of two thresholds and beta* that segment the unit interval on which beta is defined into three subintervals. These subintervals correspond to the three possible equilibria for investment flows: autarky, underinvestment, and unconstrained optimal investment. These thresholds are of interest because they can be altered by specific policy interventions. As a consequence, even if beta is small, some level of foreign investment can be supported. We construct measures of beta for 40 countries, characterize and beta*, and discuss recent trends in investment flows

Imperfect enforcement, foreign investment, and foreign aid

The lack of a supranational legal authority that can enforce private contracts across borders makes debt repayment in an international setting contingent on borrowers' willingness to pay rather than ability to pay. This market failure (i.e., inadequate enforcement) causes investment to fall short of its unconstrained level. This paper examines how foreign aid affects a country's willingness to honor private investment agreements. We consider two types of aid: technical assistance and loan subsidies. We show that when enforcement is inadequate, aid has the following effects: (i) it reduces default risk, promotes capital flows, and can, in principle, restore investment to its unconstrained level; (ii) when default risk is high, aid can increase the welfare of both the recipient and the donor country. Thus, foreign aid serves as an enforcement mechanism in an international setting. This provides a nonaltruistic rationale for foreign aid. Finally, we discuss the implications of providing bilateral versus multilateral aid (e.g., by individual countries versus multilateral organizations)