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Consumption and Debt Dynamics with (Rarely Binding) Borrowing Constraints

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Alexis Anagnostopoulos

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Abstract

This paper examines consumption and savings dynamics in a standard model of incomplete markets. Existence of equilibrium requires the imposition of exogenous debt limits but these are often ignored because of the computational difficulties that arise in models with occasionally binding constraints. I claim that borrowing constraints have a significant qualitative and quantitative effect on equilibrium allocations even if they rarely bind. Contrary to standard results in the literature, debt exhibits mean reversion, consumption responds strongly to idiosyncratic income shocks and interest rates respond to both aggregate and idiosyncratic innovations in income. The implication is that market incompleteness can generate much lower consumption correlations than was previously thought.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2004/34.

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Date of creation: 2004
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Handle: RePEc:eui:euiwps:eco2004/34

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Related research
Keywords: Incomplete markets; consumption/savings dynamics; non-linear dynamic methods;

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Find related papers by JEL classification:
C63 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Computational Techniques
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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