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Rising indebtedness and temptation: a welfare analysis

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  • Makoto Nakajima

Abstract

Is the observed large increase in consumer indebtedness since 1970 beneficial for U.S. consumers? This paper quantitatively investigates the macroeconomic and welfare implications of relaxing borrowing constraints using a model with preferences featuring temptation and self-control. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial innovation and thus better consumption smoothing, and the negative view, which is associated with consumers' over-borrowing. The author finds that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.4 percent decrease in per-period consumption from the relaxed borrowing constraint consistent with the observed increase in indebtedness. The welfare implication is strikingly different from the standard model without temptation, which implies a welfare gain of 0.7 percent, even though the two models are observationally similar. Naturally, the optimal level of the borrowing limit is significantly tighter according to the temptation model, as a tighter borrowing limit helps consumers by preventing over-borrowing.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 11-39.

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Date of creation: 2011
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Handle: RePEc:fip:fedpwp:11-39

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Keywords: Equilibrium (Economics);

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References

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  1. Benjamin A. Malin, 2007. "Hyperbolic discounting and uniform savings floors," Finance and Economics Discussion Series 2007-59, Board of Governors of the Federal Reserve System (U.S.).
  2. Igor Livshits & James MacGee & Michele Tertilt, 2006. "Accounting for the Rise in Consumer Bankruptcies," Discussion Papers 06-001, Stanford Institute for Economic Policy Research.
  3. Jeremy Tobacman & David Laibson, 2007. "Estimating Discount Functions with Consumption Choices over the Lifecycle," Economics Series Working Papers 341, University of Oxford, Department of Economics.
  4. David Laibson & Andrea Repetto & Jeremy Tobacman, 2000. "A Debt Puzzle," NBER Working Papers 7879, National Bureau of Economic Research, Inc.
  5. Juan C. Conesa & Dirk Krueger, 2004. "Taxing Capital: Not a Bad Idea After All," 2004 Meeting Papers 403, Society for Economic Dynamics.
  6. Josep Pijoan-Mas, 2004. "Precautionary Savings or Working Longer Hours?," 2004 Meeting Papers 350, Society for Economic Dynamics.
  7. Francesc Obiols-Homs, 2011. "On borrowing limits and welfare," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(2), pages 279-294, April.
  8. Per Krusell & Burhanettin Kuruscu & Anthony A. Smith, Jr., 2000. "Temptation and Taxation," GSIA Working Papers 2001-12, Carnegie Mellon University, Tepper School of Business.
  9. David I. Laibson, 1996. "Hyperbolic Discount Functions, Undersaving, and Savings Policy," NBER Working Papers 5635, National Bureau of Economic Research, Inc.
  10. Huggett, Mark, 1996. "Wealth distribution in life-cycle economies," Journal of Monetary Economics, Elsevier, vol. 38(3), pages 469-494, December.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Rising indebtedness and temptation: a welfare analysis
    by Christian Zimmermann in NEP-DGE blog on 2011-11-19 02:00:01

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