Advanced Search
MyIDEAS: Login

Endogenous Trading Constraints with Incomplete Asset Markets

Contents:

Author Info

  • Eva Carceles Poveda
  • Arpad Abraham

Abstract

The present project introduces the possibility of default on the trading contracts in an infinite horizon incomplete markets model, relaxing the usual assumption made in the literature with respect to the trading limits, which are chosen to be fixed or independent of the characteristics of the economy. In particular, it assumes that households can break their trading contracts by going into autarky, in which case they are seized from their total assets and only receive labour income from the default period on. Further, to avoid this happening in equilibrium, the trading limits are endogenously determined at the level where the participation constraint is satisfied at each possible date and state. Using this set-up, the main objectives are to quantify and characterize the endogenous limits resulting from the option of default and to study their real and financial implications along the growth path and during the business cycle. Our work is of considerable relevance, since it builds a bridge between several important strands of literature. First, it is related to the usual incomplete market models with ad hoc trading limits, such as Heaton and Lucas (1996), Marcet and Singleton (2001) or Telmer (1993), who study asset prices in two agent exchange economies, and Aiyagari (1994) or Krussel and Smith (1997) and (1998), who study production economies with a large number of households. In addition, it also relates to a recent literature, where a number of authors have introduced the possibility of default through participation constraints, resulting in agent and state specific endogenous trading limits. Among others, Kehoe and Levine (1993) and Alvarez and Jermann (2000) introduce this type of limits in exchange economies, while Kehoe and Perri (2002) analyse a production economy where investors are interpreted as countries. All these authors, however, introduce the option of default into a complete markets context, which they compare to an exogenous incomplete markets environment without explicitly characterizing the trading limits. In contrast to this, the present framework allows for a direct comparison of economies with the same asset structure, making it possible to isolate the effects of no default on the equilibrium allocations. Finally, our work is also related to the papers of Zhang (1997a) and (1997b), where the author derives the endogenous borrowing limits resulting from the possibility of default in a Lucas type exchange economy with one asset. In contrast to this, our work introduces different types of assets and incorporates a production sector, leading to state-dependent autarky values and trading limits, which considerable complicate the computations. In this respect, the contribution of the present project is also methodological, since it extends the standard policy iteration algorithm to incorporate state dependent limits and state dependent lower bounds for the grid of the endogenous states. To summarize, the present work fills an important gap in the literature, since it links the incomplete markets models with fixed trading limits and the complete markets models with the option of default, allowing for a complete characterization of the no-default endogenous trading constraints and for a better understanding of the endogenous portfolio choice problems in the absence of full commitment. Further, while our methodological contribution will enhance the understanding on the numerical techniques used to solve problems with default, it is very likely to be of use to other researchers in the field. Preliminary results on the characterization of the endogenous trading limits for the case in which a finite number of households can trade in shares of aggregate capital already shed light on important implications of the present work that can have a considerable impact on the different strands of literature studying risk sharing in infinite horizon economies. As expected, the endogenous limits do vary to a great extent with the aggregate state of the economy. In particular, when aggregate capital is scarce, and the incentives to default are relatively low, limits on individual capital shares are relatively loose. On the other hand, as the economy accumulates capital, they become tighter. Apart from this, the endogenous limits computed using a preliminary but reasonable calibration allow for short-selling of the stock in the magnitude of ten to fifteen percent of aggregate capital in the stationary distribution, being surprisingly close to the zero fixed limits usually imposed in the literature with fixed trading limits. While this is good news for the models studying steady state behaviour, it suggests that it can be dangerous to impose fixed limits during transition to the steady state, since at earlier stages of development and a relatively low capital they can vary to a great extent. In this case, the different risk sharing opportunities resulting from the presence of endogenous limits also lead to important implications concerning asset wealth and consumption inequality, which are sensitive of the particular stage on the transition path.

Download Info

To our knowledge, this item is not available for download. To find whether it is available, there are three options:
1. Check below under "Related research" whether another version of this item is available online.
2. Check on the provider's web page whether it is in fact available.
3. Perform a search for a similarly titled item that would be available.

Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 667.

as in new window
Length:
Date of creation: 2004
Date of revision:
Handle: RePEc:red:sed004:667

Contact details of provider:
Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Fax: 1-314-444-8731
Email:
Web page: http://www.EconomicDynamics.org/society.htm
More information through EDIRC

Related research

Keywords: Asset prices; Incomplete markets; Heterogeneous Agents; No-default constraints;

Other versions of this item:

Find related papers by JEL classification:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  2. Manuel S. Santos & Michael Woodford, 1997. "Rational Asset Pricing Bubbles," Econometrica, Econometric Society, vol. 65(1), pages 19-58, January.
  3. Patrick J. Kehoe & Fabrizio Perri, 2002. "Competitive equilibria with limited enforcement," Working Papers 621, Federal Reserve Bank of Minneapolis.
  4. Patrick J. Kehoe & Fabrizio Perri, 2002. "International Business Cycles with Endogenous Incomplete Markets," Econometrica, Econometric Society, vol. 70(3), pages 907-928, May.
  5. Krusell, P & Smith Jr, A-A, 1995. "Income and Wealth Heterogeneity in the Macroeconomic," RCER Working Papers 399, University of Rochester - Center for Economic Research (RCER).
  6. Huggett, Mark, 1997. "The one-sector growth model with idiosyncratic shocks: Steady states and dynamics," Journal of Monetary Economics, Elsevier, vol. 39(3), pages 385-403, August.
  7. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
  8. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & José-Víctor Ríos-Rull, 2007. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Econometrica, Econometric Society, vol. 75(6), pages 1525-1589, November.
  9. Fernando Alvarez & Urban J. Jermann, 1999. "Quantitative Asset Pricing Implications of Endogenous Solvency Constraints," NBER Working Papers 6953, National Bureau of Economic Research, Inc.
  10. Zhang, Harold H, 1997. " Endogenous Borrowing Constraints with Incomplete Markets," Journal of Finance, American Finance Association, vol. 52(5), pages 2187-2209, December.
  11. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  12. Dirk Krueger & Fabrizio Perri, 2006. "Does Income Inequality Lead to Consumption Inequality? Evidence and Theory -super-1," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 163-193.
  13. Zhang, Harold H., 1997. "Endogenous Short-Sale Constraint, Stock Prices And Output Cycles," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 228-254, January.
  14. Fernando Alvarez & Urban J. Jermann, 2000. "Efficiency, Equilibrium, and Asset Pricing with Risk of Default," Econometrica, Econometric Society, vol. 68(4), pages 775-798, July.
  15. Chris I. Telmer, 1991. "Asset Pricing Puzzles and Incomplete Markets," Working Papers 806, Queen's University, Department of Economics.
  16. Cordoba, Juan Carlos, 2010. "US Inequality: Debt Constraints or Incomplete Asset Markets?," Staff General Research Papers 32120, Iowa State University, Department of Economics.
  17. Kenneth L. Judd, 1982. "Redistributive Taxation in a Simple Perfect Foresight Model," Discussion Papers 572, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  18. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  19. Mendoza, Enrique G. & Razin, Assaf & Tesar, Linda L., 1994. "Effective tax rates in macroeconomics: Cross-country estimates of tax rates on factor incomes and consumption," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 297-323, December.
  20. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2001. "Default and Punishment in General Equilibrium," Cowles Foundation Discussion Papers 1304R5, Cowles Foundation for Research in Economics, Yale University, revised Mar 2004.
  21. S. Rao Aiyagari, 1994. "Optimal capital income taxation with incomplete markets, borrowing constraints, and constant discounting," Working Papers 508, Federal Reserve Bank of Minneapolis.
  22. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  23. David Domeij & Jonathan Heathcote, 2004. "On The Distributional Effects Of Reducing Capital Taxes," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(2), pages 523-554, 05.
  24. Krusell, Per & Smith, Anthony A., 1997. "Income And Wealth Heterogeneity, Portfolio Choice, And Equilibrium Asset Returns," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 387-422, June.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Piero Gottardi & Atsushi Kajii & Tomoyuki Nakajima, 2010. "Optimal taxation and constrained inefficiency in an infinite-horizon economy with incomplete markets," KIER Working Papers 745, Kyoto University, Institute of Economic Research.
  2. Arpad Abraham & Eva Carceles-Poveda, 2006. "Complete Markets, Enforcement Constraints and Intermediation," Computing in Economics and Finance 2006 320, Society for Computational Economics.
  3. Jenö Pál & John Stachurski, 2011. "Fitted Value Function Iteration With Probability One Contractions," ANU Working Papers in Economics and Econometrics 2011-560, Australian National University, College of Business and Economics, School of Economics.
  4. Xavier Mateos-Planas & Giulio Seccia, 2013. "Consumer Default with Complete Markets: Default-based Pricing and Finite Punishment," Working Papers 711, Queen Mary, University of London, School of Economics and Finance.
  5. Francesc Obiols-Homs, 2009. "On borrowing limits and welfare," Working Papers 401, Barcelona Graduate School of Economics.
  6. Nelnan Koumtingué & Rui Castro, 2009. "On the Optimality of Economic Integration," 2009 Meeting Papers 1043, Society for Economic Dynamics.
  7. Krueger, Dirk & Perri, Fabrizio, 2011. "Public versus private risk sharing," Journal of Economic Theory, Elsevier, vol. 146(3), pages 920-956, May.
  8. Yili Chien & Junsang Lee, 2006. "Why Tax Capital?," 2006 Meeting Papers 492, Society for Economic Dynamics.
  9. Juan M. Sanchez, 2009. "The role of information in the rise in consumer bankruptcies," Working Paper 09-04, Federal Reserve Bank of Richmond.
  10. Juan M. Sanchez, 2008. "The Role of Information in Consumer Debt and Bankruptcy," 2008 Meeting Papers 523, Society for Economic Dynamics.
  11. CASTRO, Rui & KOUMTINGUÉ, Nelnan, 2011. "On the Individual Optimality of Economic Integration," Cahiers de recherche 2011-04, Universite de Montreal, Departement de sciences economiques.
  12. Eva Carceles-Poveda, 2009. "Asset Prices and Business Cycles under Market Incompleteness," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(3), pages 405-422, July.
  13. Bejan, Camelia & Bidian, Florin, 2010. "Limited enforcement, bubbles and trading in incomplete markets," MPRA Paper 36819, University Library of Munich, Germany, revised 20 Feb 2012.
  14. Ramon Marimon & Eva Carceles-Poveda & Arpad Abraham, 2012. "On the optimal design of a Financial Stability Fund," 2012 Meeting Papers 945, Society for Economic Dynamics.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:red:sed004:667. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.