Equilibrium Default and Temptation

Makoto Nakajima ()

No 863, 2009 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper I quantitatively investigate macroeconomic and welfare implications of the recent consumer bankruptcy law reform using a general equilibrium life-cycle model with unsecured debt and equilibrium default where agents have preferences featuring temptation and self-control problems. The preference used here includes quasi-hyperbolic discounting as the extreme case where temptation is infinitely strong. The key components of the U.S. bankruptcy law reform which was enacted in 2005 are (i) subjecting filers to means-testing, and (ii) increased cost of filing for bankruptcy. I find that, both the standard model with exponential discounting and the model with temptation and self-control (or quasi-hyperbolic discounting) do well in replicating the responses of the U.S. economy after the bankruptcy reform. Both models correctly predict that the number of bankruptcy filings decrease, and the amount of loans and the average interest rate of loans do not change substantially. However, the macroeconomic implications of the recent bankruptcy reform will crucially depend on what type of shocks is dominant. In particular, if defaults are not mainly due to expenditure shocks, but rather due to series of unfavorable income realizations, models with exponential discounting predict an increase in the number of bankruptcy filings, while models with temptation and self-control still predict a decrease in the number of bankruptcy filings in response to the recent bankruptcy reform. Regarding the welfare implications of the bankruptcy law reform, the implications from different models are similar; both models with exponential discounting and those with temptation and self-control imply welfare loss from the bankruptcy reform, mainly because of the loss of welfare of those who cannot file even if they want. I also find that, if the same level of punishment for bankruptcy is used, models with temptation and self-control problem generates a larger debt and more bankruptcy filings than the model with exponential discounting.

Date: 2009
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