Internal finance and capital accumulation in a dynamic general equilibrium model with credit constraints

SummaryThis paper uses a dynamic general equilibrium setup with overlapping generations to provide a better understanding of the causes and consequences of credit constraints resulting from asymmetric information and moral hazard. These constraints imply that the entrepreneur’s access to credit is limited by the amount of internal funds available. In a general equilibrium setup, internal funds and the interest rate are endogenous. It is shown that credit constraints have large effects either by redistributing wealth or by changing the equilibrium capital stock, or both. Insofar as the interest rate elasticity of savings is close to zero, the effects on income distribution are likely to be much more important than the effects on output and investment. Even though Pareto improving policies do exist, they seem extremely difficult to implement in practice. Even in our simple setup with no borrower heterogeneity, simple transfers from unconstrained households to finance-constrained entrepreneurs may well fail to lead to Pareto superior outcomes and to eliminate the inefficiencies generated by capital market imperfections, even though they would have a positive impact on aggregate investment and output.