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A tale of two commitments: equilibrium default and temptation

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Listed author(s):
  • Nakajima, Makoto

    (Federal Reserve Bank of Philadelphia)

Abstract

I construct the life-cycle model with equilibrium default and preferences featuring temptation and self-control. The model provides quantitatively similar answers to positive questions such as the causes of the observed rise in debt and bankruptcies and macroeconomic implications of the 2005 bankruptcy reform, as the standard model without temptation. However, the temptation model provides contrasting welfare implications, because of overborrowing when the borrowing constraint is relaxed. Specifically, the 2005 bankruptcy reform has an overall negative welfare effect, according to the temptation model, while the effect is positive in the no-temptation model. As for the optimal default punishment, welfare of the agents without temptation is maximized when defaulting results in severe punishment, which provides a strong commitment to repaying and thus a lower default premium. On the other hand, welfare of agents with temptation is maximized when weak punishment leads to a tight borrowing constraint, which provides a commitment against overborrowing.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 14-1.

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Length: 39 pages
Date of creation: 11 Dec 2013
Handle: RePEc:fip:fedpwp:14-1
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Keywords: Consumer bankruptcy; Debt; Default; borrowing constraint; Temptation and self-control; Hyperbolic-discounting; Heterogeneous agents; Incomplete markets;

Find related papers by JEL classification:

  • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
  • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
  • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
  • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
  • K35 - Law and Economics - - Other Substantive Areas of Law - - - Personal Bankruptcy Law

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  1. R. A. Pollak, 1968. "Consistent Planning," Review of Economic Studies, Oxford University Press, vol. 35(2), pages 201-208.
  2. Juan Carlos Conesa & Sagiri Kitao & Dirk Krueger, 2009. "Taxing Capital? Not a Bad Idea after All!," American Economic Review, American Economic Association, vol. 99(1), pages 25-48, March.
  3. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2010. "The Macroeconomic Implications of Rising Wage Inequality in the United States," Journal of Political Economy, University of Chicago Press, vol. 118(4), pages 681-722, 08.
  4. Attanasio, Orazio P & Weber, Guglielmo, 1995. "Is Consumption Growth Consistent with Intertemporal Optimization? Evidence from the Consumer Expenditure Survey," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1121-1157, December.
  5. Malin, Benjamin A., 2008. "Hyperbolic discounting and uniform savings floors," Journal of Public Economics, Elsevier, vol. 92(10-11), pages 1986-2002, October.
  6. Michelle J. White, 2007. "Bankruptcy Reform and Credit Cards," NBER Working Papers 13265, National Bureau of Economic Research, Inc.
  7. Michelle J. White, 2007. "Bankruptcy Reform and Credit Cards," Journal of Economic Perspectives, American Economic Association, vol. 21(4), pages 175-200, Fall.
  8. Robert J. Barro, 1999. "Ramsey Meets Laibson in the Neoclassical Growth Model," The Quarterly Journal of Economics, Oxford University Press, vol. 114(4), pages 1125-1152.
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Cited by:

  1. Viktar Fedaseyeu, 2012. "Debt Collection Agencies and the Supply of Consumer Credit," Working Papers 442, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.

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