Rising Indebtedness and Hyperbolic Discounting: A Welfare Analysis

Abstract

Is the observed large increase in consumer indebtedness since the 1980s beneficial for U.S. consumers? This paper quantitatively studies the macroeconomic and welfare implications of relaxing borrowing constraints when consumers exhibit a hyperbolic discounting preference. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial innovation and thus better insurance, and the negative view, which is associated with consumers' over-borrowing. I find that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.2% decrease in per-period consumption from the relaxed borrowing constraint consistent with the observed increase in indebtedness. The welfare implication is strikingly different from the model with the standard exponential discounting preference, which implies a welfare gain of 0.6%, even though the two models are observationally similar. Naturally, according to the hyperbolic discounting model, there is a welfare gain from restricting consumer borrowing in the current U.S. economy.

Keywords: Hyperbolic discounting, Over-borrowing, Borrowing constraint, Heterogeneous agents, General equilibrium

JEL Classification: D91, E21, E44, G18