A tale of two commitments: equilibrium default and temptation

Makoto Nakajima ()

No 14-1, Working Papers from Federal Reserve Bank of Philadelphia

Abstract: I construct the life-cycle model with equilibrium default and preferences featuring temptation and self-control. The model provides quantitatively similar answers to positive questions such as the causes of the observed rise in debt and bankruptcies and macroeconomic implications of the 2005 bankruptcy reform, as the standard model without temptation. However, the temptation model provides contrasting welfare implications, because of overborrowing when the borrowing constraint is relaxed. Specifically, the 2005 bankruptcy reform has an overall negative welfare effect, according to the temptation model, while the effect is positive in the no-temptation model. As for the optimal default punishment, welfare of the agents without temptation is maximized when defaulting results in severe punishment, which provides a strong commitment to repaying and thus a lower default premium. On the other hand, welfare of agents with temptation is maximized when weak punishment leads to a tight borrowing constraint, which provides a commitment against overborrowing.

Keywords: Consumer bankruptcy; Debt; Default; borrowing constraints; Temptation and self-control; hyperbolic discounting; Heterogeneous agents; Incomplete markets (search for similar items in EconPapers)
JEL-codes: D91 E21 E44 G18 K35 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2013-12-11
New Economics Papers: this item is included in nep-dge, nep-law and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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