DP261 | Moral Hazard and Limited Liability in the Market for Loans: Credit Restriction Versus Credit Rationing

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This paper develops a model of equilibrium in the market for loans. It focuses on the effects on equilibrium of (i) differences in the liability of the lender and the borrower for losses; and (ii) differences in the information available to the lender. We examine the different types of imperfection in the credit market which arise as a consequence of these differences and draw a distinction between outcomes where credit is rationed (the borrower would wish to borrow more at some interest rate) and those where credit is restricted (the borrower is able to borrow less than he would be able to were some imperfection removed). We demonstrate unambiguous propositions about credit restriction, but in the model we examine, this need not necessarily be accompanied by credit rationing.