Collateral, Default Penalties and Endogenous Debt Constraints
V. Filipe Martins-da-Rocha
Graduate School of Economics, Getulio Vargas Foundation
affiliation not provided to SSRN
June 18, 2008
Araujo, Pascoa and Torres-Martinez (2002) have shown that, without imposing any (endogenous) debt constraint or transversality condition, Ponzi schemes are ruled out in infinite horizon economies provided that collateral is the only mechanism that enforces agents to pay their debts. Recently, Pascoa and Seghir (2008) have shown that Ponzi schemes may reappear in collateralized economies in the presence of additional enforcement mechanisms such as default penalties. However, the authors claimed that collateral still avoids Ponzi schemes provided that default penalties are moderate.
The objective of this paper is two fold. Contrary to what was claimed by Piscoa and Seghir (2008), we first show that moderate default penalties are not always compatible with equilibrium existence. This observation leads us to argue in favor of endogenous debt constraints to restore equilibrium in economies with collateral and default penalties. We show that it is possible to adapt the approach of imposing restrictions on available plans through finitely effective debt constraints, introduced by Levine and Zame (1996), to encompass models with collateral and default penalties.
Number of Pages in PDF File: 44
Keywords: Infinite horizon economies, Incomplete markets, Debt constraints, Default, Collateral, Ponzi schemes
JEL Classification: D52, D91working papers series
Date posted: September 6, 2008 ; Last revised: September 11, 2008
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