Credit Market Imperfections and Macroeconomic Instability

• Author: Takuma Kunieda,Akihisa Shibata
• Date: 01 December 2014
• Published date: 01 December 2014
• DOI: http://doi.org/10.1111/1468-0106.12085

CREDIT MARKET IMPERFECTIONS AND

MACROECONOMIC INSTABILITY

TAKUMA KUNIEDA City University of Hong Kong

AKIHISA SHIBATA*Kyoto University

Abstract. Credit market imperfections typically characterize a low quality financial market, where

the quality of information about borrowers is low and/or enforcement rules or institutions are not

well developed. We consider an economy with credit market imperfections and analyse how changes

in the degree of credit constraints affect economic fluctuations. The analysis demonstrates that if the

degree of credit market imperfection is either severe or too soft, the economy converges to an

asymptotically stable steady state, whereas if the degree of imperfection is moderate, the equilibrium

involves deterministic cycles or chaos.

1. INTRODUCTION

Developing a new economic theory of market quality, Yano (2008, 2009)

emphasizes that high market quality is an essential precondition for achieving

healthy economic growth and that the lack of high quality markets causes

fundamental malfunctions in the market allocation mechanism. According to

Yano (2008, 2009), the basic determinants of market quality are quality of

competition, quality of information and product quality. To assure high quality

of competition and information, we require the establishment of solid market

infrastructure, such as fair laws and rules, healthy institutions and organiza-

tions, and good culture and customs for agents in economies.

Thus far, several researchers have addressed these basic determinants of

market quality. Focusing on the labour market, Dei (2011) models a developing

economy in which the quality of the labour market is endogenously determined

through voting, and shows that if the voting takes place at the wrong time, the

country suffers from a low quality labour market. Ma and Dei (2009) examine

the issue of product quality in a model of Chinese trade. Furukawa (2010)

applies the market quality theory to the intellectual property rights market in a

dynamic setting. These studies, which belong to the market quality literature, do

*Address for Correspondence: Institute of Economic Research, Kyoto University, Yoshida-

Honmachi, Sakyo-ku, Kyoto 606–8501, Japan. E-mail: shibata@kier.kyoto-u.ac.jp. Shibata has

received financial support through a JSPS Grant-in-Aid for Specially Promoted Research

(No.23000001) and a JSPS Grant-in-Aid for Scientific Research (No. 23330060), and Kunieda has

received financial support from the City University of Hong Kong (No. 7200307). The authors

would like to express thanks to an anonymous referee and to Hiroki Arato, Costas Azariadis, Volker

Böhm, Raouf Boucekkine, Oded Galor, Takeo Hori, Peter Howitt, Tomoo Kikuchi, Kazuo Mino,

Kazuo Nishimura, Makoto Saito, Masaya Sakuragawa, Etsuro Shioji, Zheng Michael Song, Alain

Venditti and David Weil. The authors are also grateful to seminar participants at the Chinese

University of Hong Kong and Hitotsubashi University, and participants of the 2011 Asia-Pacific

Journal of Accounting and Economics Symposium on Dynamic System and World Trade at City

University of Hong Kong and the 4th Workshop on Macroeconomic Dynamics at the National

University of Singapore for their comments.

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Pacific Economic Review, 19: 5 (2014) pp. 592–611

doi: 10.1111/1468-0106.12085

© 2014 Wiley Publishing Asia Pty Ltd

not deal with the quality of financial markets. In contrast, Savtchenko (2010)

investigates the quality of information in the international financial market.

Savtchenko (2010, p. 196) states that ‘markets characterized by currency crises

cannot be called high quality markets’, and shows that, when economic agents

possess only private information, a currency crisis in a country can be triggered

by a similar event in another country. Our paper also deals with the quality of

financial markets, but, unlike Savtchenko (2010), we consider a closed economy

that faces credit constraints, and explicitly investigate how the degree of credit

constraints affects economic fluctuations. It should be noted here that low

quality financial markets are typically characterized by the presence of credit

constraints. This may reflect the poor quality of information about borrowers

and/or the lack of well-developed enforcement rules or institutions in such

markets.

There are two major reasons why we focus on financial markets. First, a large

number of economists, in the tradition of Keynes (1936), have viewed the

financial sector as the source of business fluctuations. Second, there is much

empirical support for this view. For example, several well-known historical

episodes, such as the Great Depression before World War II, the lost decade in

Japan after the boom of the 1980s and the subprime loan problems in the late

2000s, are consistent with this view. More recently, several researchers, such as

Easterly et al. (2000), Denizer et al. (2002) and Beck et al. (2006), have presented

empirical evidence indicating that financial development has a negative effect on

the volatility of an economy.

In our model, agents within the same generation are heterogeneous with

respect to their productivity in creating capital goods. Each agent has two saving

methods. The first involves depositing part of one’s wage income in a financial

intermediary, and the second is to start an investment project. In equilibrium,

less talented agents deposit part of their wage income in the financial intermedi-

ary, and do not start investment projects. They are analogous to the agents in

Samuelson’s consumption loan model. In contrasts, agents that are more tal-

ented start investment projects. These parallel the agents in Diamond’s produc-

tion economy. Our main result is as follows. If credit constraints are either

severe or too soft, an economy converges to an asymptotically stable steady

state, but if credit constraints are moderate, deterministic cycles or chaos can

arise.

We use the degree of credit constraints to denote the degree of financial

development: as the financial sector develops, credit constraints are relaxed.

Moreover we employ Cobb–Douglas utility and production functions. With

Cobb–Douglas utility and production functions, a perfect financial market does

not generate endogenous business cycles; however, an imperfect financial

market might do so. This fact indicates that the chaotic dynamics in our model

arise due to the moderate degree of financial development.

The rest of the paper is organized as follows. In the next section, we discuss

the literature related to our study. The model is presented in Section 3. In

Section 4, we derive a competitive equilibrium, and in Section 5, we investigate

the dynamic properties of the economy. In Section 6, we provide a discussion

CREDIT MARKET IMPERFECTIONS AND MACROECONOMIC INSTABILITY

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© 2014 Wiley Publishing Asia Pty Ltd