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On Modelling Endogenous Default

  • Dimitrios Tsomocos


  • Lea Zicchino

Not only in the classic Arrow-Debreu model, but also in many mainstream macro models, an implicit assumption is that all agents honour their obligations, and thus there is no possibility of default. That leads to well-known problems in providing an essential role for either money or for financial intermediaries. So, in more realistic models, the introduction of minimal financial institutions, for example default and banks, becomes a logical necessity. But if default involved no penalties, everyone would do so. Hence there must be default penalties to allow for an equilibrium with partial default. What we show here is that there is an equivalence between a general equilibrium model with incomplete markets (GEI) and endogeneous default, and a model with exogenous probabilities of default (PD). The practical, policy implications are that a key function of regulators (via bankruptcy codes and default legislation), or the markets (through default premia) are broadly substitutable. The balance between these alternatives depends, however, on many institutional details, which are not modelled here, but should be a subject for future research.

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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp548.

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Date of creation: Oct 2005
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Handle: RePEc:fmg:fmgdps:dp548
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  1. repec:tpr:qjecon:v:109:y:1994:i:4:p:841-79 is not listed on IDEAS
  2. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. Oliver Hart & John Moore, 1991. "A Theory of Debt Based on the Inalienability of Human Capital," STICERD - Theoretical Economics Paper Series 233, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  4. Aloisio Araujo & M�rio Rui P�scoa & Juan Pablo Torres-Mart�nez, 2002. "Collateral Avoids Ponzi Schemes in Incomplete Markets," Econometrica, Econometric Society, vol. 70(4), pages 1613-1638, July.
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