Rising Indebtedness and Temptation: A Welfare Analysis

37 Pages Posted: 15 Sep 2011

See all articles by Makoto Nakajima

Makoto Nakajima

Federal Reserve Bank of Philadelphia

Date Written: September 14, 2011

Abstract

Is the observed large increase in consumer indebtedness since 1970 beneficial for U.S. consumers? This paper quantitatively investigates the macroeconomic and welfare implications of relaxing borrowing constraints using a model with preferences featuring temptation and self-control. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial innovation and thus better consumption smoothing, and the negative view, which is associated with consumers' over-borrowing. The author finds that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.4 percent 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 standard model without temptation, which implies a welfare gain of 0.7 percent, even though the two models are observationally similar. Naturally, the optimal level of the borrowing limit is significantly tighter according to the temptation model, as a tighter borrowing limit helps consumers by preventing over-borrowing.

Keywords: Temptation, Self-control, Hyperbolic discounting, Over-borrowing, Heterogeneous agents, General equilibrium

JEL Classification: D91, E21, E44, G18

Suggested Citation

Nakajima, Makoto, Rising Indebtedness and Temptation: A Welfare Analysis (September 14, 2011). FRB of Philadelphia Working Paper No. 11-39, Available at SSRN: https://ssrn.com/abstract=1927524 or http://dx.doi.org/10.2139/ssrn.1927524

Makoto Nakajima (Contact Author)

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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