11. Credit Markets and Wealth Constraints

This chapter considers the principal-agent model of lending and borrowing, revealing common properties with previous models where contracts cannot fully guarantee all aspects of an exchange. In the credit market, the contract specifies an amount to be repaid, but enforceability is difficult due to limited liability laws and a borrower's limited (or no) wealth. This contractual incompleteness results in Pareto-efficient Nash equilibria where the agent receives a rent and the principal exercises power over the agent.

The chapter highlights that wealthy individuals are advantaged in credit markets, paying lower interest rates, financing larger projects, and even financing projects of lower quality. This creates a positive feedback loop, sustaining elevated levels of wealth inequality. The chapter also explains how credit market exclusion or quantity constraints on borrowers can impact consumption smoothing. This can explain macroeconomic phenomena like the Keynesian multiplier, which is due to the fact that income shocks result in expenditure shocks because households’ are limited in what they can borrow, without relying on ad hoc cognitive failures.