Credit Markets, Limited Commitment, and Government Debt

Stephen Williamson and Francesca Carapella

No 226, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: 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.

Date: 2012
New Economics Papers: this item is included in nep-ban, nep-cta and nep-dge
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Related works:
Journal Article: Credit Markets, Limited Commitment, and Government Debt (2015)
Working Paper: Credit markets, limited commitment, and government debt (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed012:226

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