with Giulio Seccia

Abstract: This paper studies economies with complete markets where there is positive default on consumer debt. In a simple tractable two-period model, households can default partially, at a finite punishment cost, and competitive intermediaries price the risk of loans of different size separately. This environment yields only partial insurance. The risk-based pricing of debt makes it too costly for the borrower to achieve full insurance and there is too little trade in securities. Consumption is positively correlated with idiosyncratic changes in income. This approach is in contrast with existing literature. Unlike the literature with default, there are no restrictions on the set of state contingent securities that are issued. Unlike the literature on lack of commitment, limited trade arises without debt constraints that rule default out. The approach in this paper seems to imply more consumption inequality than the latter. An extended model with an infinite horizon, idiosyncratic risk and more realistic assumptions is used to demonstrate the general validity of the approach and its main implications.

Economic Theory (2014) 56:549–583 download