Performance of an economy with credit constraints, bankruptcy and labor inflexibility

We present a static general equilibrium model of an economy with agents with heterogenous wealth and endogenous credit constraints due to moral hazard. Credit constraints give rise to inefficiencies which are larger if wealth is distributed more unequally. We show that increases in the loan recovery rate improve the efficiency of the economy and raise the equilibrium interest rate. We also determine the sensitivity of the economy to the wealth distribution, and how this response depends on the loan recovery rate. We examine these results in an open economy, where interest rate increases are translated into inflows of capital due to improvements in loan recovery. The previous results are compounded if the economy faces labor inflexibilities, so smaller increases in inequality lead to productive inefficiencies and to lower wages. We simulate our model economy to determine the importance of these effects.