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Fragility of Competitive Equilibrium with Risk of Default

  • Gaetano Bloise

    (University of Rome III)

  • Pietro Reichlin

    (LUISS)

  • Mario Tirelli

    (University of Rome III)

We study competitive equilibrium in sequential economies under limited commitment. Default induces permanent exclusion from financial markets and endogenously determined solvency constraints prevent debt repudiation. Our analysis shows that such an enforcement mechanism is essentially fragile, leading to equilibrium multiplicity. We accomplish this by establishing Welfare Theorems under a weaker notion of constrained efficiency, inspired by Malinvaud, corresponding to the absence of welfare mproving feasible redistributions over finite (though indefinite) horizons. A Negishi's Method permits to show that, for any arbitrary value of social welfare in between autarchy and constrained optimality, there exists an equilibrium attaining that value. Thus, competitive equilibria might differ dramatically in terms of volumes of trade, asset price volatility, individuals' ability to insure against idiosyncratic risk and consumption inequality. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2013.01.002
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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 16 (2013)
Issue (Month): 2 (April)
Pages: 271-295

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Handle: RePEc:red:issued:11-290
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