Handout Class 4

Alessandro Di Nola
November 2012

Kiyotaki and Moore

1

The modelling choices

I presented you in class a simplied version of the Kyotachi-Moore model that introduces credit
market imperfections into the picture of real business cycle models. The reference is the paper
Credit Cyclesby Kiyotaki and Moore (1997), JPE, 211-248 that you nd in Prof. Giavazzis
reading list.
The model can be made quite simple even though it features heterogenous agents by adding to
it the following features:
1. A constant interest rate (one less variable), it follows from households having linear preferences
over conumption (see below).
2. No labor supply decision.
3. No variable capital.
4. Only one asset that can be used for production, and is available in xed supply in the aggregate
(call it land). It also serves as a collateral constraint for the borrowers.

A Basic Model

There are two types of agents, farmers (productive) and gatherers (unproductive). They both
have linear preferences over consumption, but they discount the future dierently. Farmers have a
discount factor of ; gatherers have a discount factor of ; where

> :

They produce a nal good yt using land ht . The production functions are respectively described
by:
yt = At hvt 1 ;
yt0 = A0t h0t

2.1

1:

Gatherers

The gatherers will be the unproductiveagents, and they will lend to other agents. They solve the
following problems
X

max E0

c0t ;h0t ;b0t

s.t.
c0t + qt h0t + Rb0t

t 0
ct

= yt0 + qt h0t

+ b0t :

where b0t denotes the amount of new debt issued in period t. Notice that in equilibrium b0t is actually
negative, reecting the fact that gatherers are creditors to the farmers.
By sustituting the budget constraint into the objective function we get the following equivalent
unconstrained problem1 :
max
E0
0 0
ht ;bt

where yt0 = A0t h0t

yt0 + qt h0t

+ b0t

qt h0t

Rb0t

of course. The rst order conditions are, choosing b0t and h0t respectively:
R = 1;
qt =

0
yt+1
h0t

Et qt+1 +

Linear preferences over consumption imply that in equilibrium the gatherers must be indierent
about any path of consumption and debt, so that the interest rate will equal their rate of time
preference, and R = 1= .

2.2

Farmers

Farmers maximize

max E0

ct ;ht ;bt

their ows of funds is

ct + qt ht + Rbt
1

ct

= y t + q t ht

+ bt ;

If you prefer you can use the Lagrangian, but here the substitution method is faster.

where on the right-hand side we have the sources of funds, on the left-hand side we have its uses.
The amount of claims farmers can issue is bound by:
Rbt

mEt (qt+1 ht ):

(1)

The credit constraint arises due to limited enforcement of contracts. It is assumed in fact that
lenders cannot force borrowers to repay their debts unless the debts are secured by land. The
lenders therefore take care never to allow the size of the debt (gross of interest, which is the LHS
of 1) to exceed the values of the collateral (which is the RHS of 1). Specically, if at date t the
farmer/borrower has land ht then he can borrow bt in total, as long as the repayment does not
exceed the market value of his land at date t + 1. The parameter m indexes the amount of credit
frictions that aect the economy.
The Lagrangean for this problem is:
L = E0

1
X

(yt + qt ht

+ bt

q t ht

Rbt

1)

t (mqt+1 ht

Rbt )

t=0

where yt = At hvt

and

is the non-negative multiplier attached to the inequality constraint

(1).
The Kuhn-Tucker necessary conditions are:
1 =

R+

qt =
t (mqt+1 ht

mqt+1 ht

Et

t R;

(2)

yt+1
qt+1 +
ht

+ Et ( t mqt+1 ) ;

(3)

Rbt ) = 0;

(4)

0;

(5)

Rbt

0:

(6)

From the rst equation we nd

t

R
R

> 0;

which implies that the multiplier is constant over time and strictly positive. By (4) the borrowing
constraint must be binding at each date: mqt+1 ht

Rbt = 0 8t:

2.3

Equilibrium

Collecting all the equilibrium equations and eliminating the multiplier gives:
c0t + qt h0t + Rb0t

= yt0 + qt h0t

ct + qt ht + Rbt

= y t + q t ht

qt =

Et

+ b0t

(7)

+ bt
y0
qt+1 + t+1
h0t

qt = (m + (1

m) ) Et qt+1 +

Rbt = mEt (qt+1 ht )

(8)
(9)
Et

yt+1
ht

(10)
(11)

ht + h0t = 1

(12)

bt + b0t = 0

(13)

yt = At hvt

(14)

yt0 = A0t h0t

(15)

There are three markets: the market for loans b, goods y and market for land h. Equation
(12) is the market clearing condition for land2 , (13) is the market clearing condition for bonds.
Remember that by WalrasLaw if the bond market and the land market clear, so will the goods
one, and hence we dont need to write down the market clearing condition for goods. A quick check:
9 equations, whereas the variables are c0t , ct , yt , yt0 , ht , h0t , bt , b0t , qt .

I normalized to 1 total supply of land.