A Tale of Two Commitments: Equilibrium Default and Temptation

40 Pages Posted: 17 Dec 2013

See all articles by Makoto Nakajima

Makoto Nakajima

Federal Reserve Bank of Philadelphia

Date Written: December 11, 2013

Abstract

I construct the life-cycle model with equilibrium default and preferences featuring temptation and self-control. The model provides quantitatively similar answers to positive questions such as the causes of the observed rise in debt and bankruptcies and macroeconomic implications of the 2005 bankruptcy reform, as the standard model without temptation. However, the temptation model provides contrasting welfare implications, because of overborrowing when the borrowing constraint is relaxed. Specifically, the 2005 bankruptcy reform has an overall negative welfare effect, according to the temptation model, while the effect is positive in the no-temptation model. As for the optimal default punishment, welfare of the agents without temptation is maximized when defaulting results in severe punishment, which provides a strong commitment to repaying and thus a lower default premium. On the other hand, welfare of agents with temptation is maximized when weak punishment leads to a tight borrowing constraint, which provides a commitment against overborrowing.

Keywords: Consumer bankruptcy, Debt, Default, Borrowing constraint, Temptation and self-control, Hyperbolic-discounting, Heterogeneous agents, Incomplete markets

JEL Classification: D91, E21, E44, G18, K35

Suggested Citation

Nakajima, Makoto, A Tale of Two Commitments: Equilibrium Default and Temptation (December 11, 2013). FRB of Philadelphia Working Paper No. 14-1, Available at SSRN: https://ssrn.com/abstract=2368470 or http://dx.doi.org/10.2139/ssrn.2368470

Makoto Nakajima (Contact Author)

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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