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Consumer Default with Complete Markets: Default-based Pricing and Finite Punishment

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    This paper studies economies with complete markets where there is positive default on consumer debt. In a simple tractable two-period model, households can default partially, at a finite punishment cost, and competitive intermediaries price loans of different sizes separately. This environment yields only partial insurance. The default-based pricing of debt makes it too costly for the borrower to achieve full insurance and there is too little trade in securities. This framework is in contrast with existing literature. Unlike the literature with default, there are no restrictions on the set of state contingent securities that are issued. Unlike the literature on lack of commitment, limited trade arises without need of debt constraints that rule default out. Compared with the latter, the present approach appears to imply more consumption inequality. An extended model with an infinite horizon, idiosyncratic risk and more realistic assumptions is used to demonstrate the general validity of this approach and its main implications.

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    Paper provided by Queen Mary University of London, School of Economics and Finance in its series Working Papers with number 711.

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    Date of creation: Nov 2013
    Date of revision:
    Handle: RePEc:qmw:qmwecw:wp711
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    1. Igor Livshits & James MacGee & Michele Tertilt, 2003. "Consumer bankruptcy: a fresh start," Working Papers 617, Federal Reserve Bank of Minneapolis.
    2. Broer, Tobias, 2011. "The wrong shape of insurance? What cross-sectional distributions tell us about models of consumption-smoothing," CEPR Discussion Papers 8701, C.E.P.R. Discussion Papers.
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    4. Kyle F. Herkenhoff, 2012. "Informal unemployment insurance and labor market dynamics," Working Papers 2012-057, Federal Reserve Bank of St. Louis.
    5. Satyajit Chatterjee, 2015. "An Equilibrium Model of the Timing of Bankruptcy Filings," 2015 Meeting Papers 487, Society for Economic Dynamics.
    6. Rubén Poblete-Cazenave & Juan Pablo Torres-Martínez, 2010. "Equilibrium with limited-recourse collateralized loans," Working Papers wp313, University of Chile, Department of Economics.
    7. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2008. "The Macroeconomic Implications of Rising Wage Inequality in the United States," NBER Working Papers 14052, National Bureau of Economic Research, Inc.
    8. Fernández-Villaverde, Jesús & Krueger, Dirk, 2011. "Consumption And Saving Over The Life Cycle: How Important Are Consumer Durables?," Macroeconomic Dynamics, Cambridge University Press, vol. 15(05), pages 725-770, November.
    9. Cordoba, Juan-Carlos, 2008. "U.S. inequality: Debt constraints or incomplete asset markets?," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 350-364, March.
    10. Andolfatto, David & Gervais, Martin, 2008. "Endogenous debt constraints in a life-cycle model with an application to social security," Journal of Economic Dynamics and Control, Elsevier, vol. 32(12), pages 3745-3759, December.
    11. 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.
    12. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    13. Xavier Mateos-Planas & David Benjamin, 2012. "Formal vs. Informal Default in Consumer Credit," 2012 Meeting Papers 144, Society for Economic Dynamics.
    14. Ábrahám, Árpád & Cárceles-Poveda, Eva, 2010. "Endogenous trading constraints with incomplete asset markets," Journal of Economic Theory, Elsevier, vol. 145(3), pages 974-1004, May.
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    18. repec:bla:restud:v:48:y:1981:i:2:p:289-309 is not listed on IDEAS
    19. Mateos-Planas, Xavier & Seccia, Giulio, 2006. "Welfare implications of endogenous credit limits with bankruptcy," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2081-2115, November.
    20. Javier Díaz-Giménez & Andrew Glover & José-Víctor Ríos-Rull, 2011. "Facts on the distributions of earnings, income, and wealth in the United States: 2007 update," Quarterly Review, Federal Reserve Bank of Minneapolis.
    21. Thorsten Koeppl, 2005. "Optimal Dynamic Risk Sharing when Enforcement is a Decision Variable," Working Papers 1050, Queen's University, Department of Economics.
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    24. Athreya, Kartik & Tam, Xuan S. & Young, Eric R., 2009. "Unsecured credit markets are not insurance markets," Journal of Monetary Economics, Elsevier, vol. 56(1), pages 83-103, January.
    25. repec:bla:restud:v:51:y:1984:i:3:p:393-414 is not listed on IDEAS
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