26 Pages Posted: 14 Apr 2006 Last revised: 22 Jul 2010
Date Written: January 2006
This paper characterizes the equilibrium dynamics in an economy facing an aggregate debt ceiling. This borrowing limit is intended to capture an environment in which foreign investors base their lending decisions predominantly upon macro indicators. Individual agents do not internalize the borrowing constraint. Instead, a country interest-rate premium emerges to clear the financial market. The implied equilibrium dynamics are compared to those arising from a model in which the debt ceiling is imposed at the level of each individual agent. The central finding of the paper is that the economy with the aggregate borrowing limit does not generate higher levels of debt than the economy with the individual borrowing limit. That is, there is no overborrowing in equilibrium.
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