By Árpád Ábrahám and Eva Cárceles-Poveda
This paper studies a production economy with aggregate uncertainty where consumers have limited commitment on their financial liabilities. Markets are endogenously incomplete due to the fact that the borrowing constraints are determined endogenously. We first show that, if competitive financial intermediaries are allowed to set the borrowing limits, then the ones that prevent default will be an equilibrium outcome. The equilibrium allocations in this economy are not constrained efficient due to the fact that intermediaries do not internalize the adverse effects of capital on default incentives. We also isolate and quantify this new source of inefficiency by comparing the competitive equilibrium allocations to the constrained efficient ones both qualitatively and quantitatively. We tend to observe higher capital accumulation in the competitive equilibrium, implying that agents may enjoy higher (average) welfare in the long run than in the constrained efficient allocation.
This is an interesting model of economic fluctuations under limited commitment and endogenous borrowing limits. In particular it highlights how unregulated lending markets do internalize default incentives, and thus lead to suboptimal outcomes.