Dynamic Financial Constraints: Distinguishing Mechanism Design from Exogenously Incomplete Regimes

66 Pages Posted: 9 Nov 2013

See all articles by Alexander Karaivanov

Alexander Karaivanov

Simon Fraser University (SFU) - Department of Economics

Robert M. Townsend

Massachusetts Institute of Technology (MIT)

Date Written: November 2013

Abstract

We formulate and solve a range of dynamic models of constrained credit/insurance that allow for moral hazard and limited commitment. We compare them to full insurance and exogenously incomplete financial regimes (autarky, saving only, borrowing and lending in a single asset). We develop computational methods based on mechanism design, linear programming, and maximum likelihood to estimate, compare, and statistically test these alternative dynamic models with financial/information constraints. Our methods can use both cross-sectional and panel data and allow for measurement error and unobserved heterogeneity. We estimate the models using data on Thai households running small businesses from two separate samples. We find that in the rural sample, the exogenously incomplete saving only and borrowing regimes provide the best fit using data on consumption, business assets, investment, and income. Family and other networks help consumption smoothing there, as in a moral hazard constrained regime. In contrast, in urban areas, we find mechanism design financial/information regimes that are decidedly less constrained, with the moral hazard model fitting best combined business and consumption data. We perform numerous robustness checks in both the Thai data and in Monte Carlo simulations and compare our maximum likelihood criterion with results from other metrics and data not used in the estimation. A prototypical counterfactual policy evaluation exercise using the estimation results is also featured.

Suggested Citation

Karaivanov, Alexander and Townsend, Robert M., Dynamic Financial Constraints: Distinguishing Mechanism Design from Exogenously Incomplete Regimes (November 2013). NBER Working Paper No. w19617. Available at SSRN: https://ssrn.com/abstract=2352134

Alexander Karaivanov (Contact Author)

Simon Fraser University (SFU) - Department of Economics ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

Robert M. Townsend

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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