Welfare implications of endogenous credit limits with bankruptcy

This paper studies the aggregate welfare consequences of changes in the prescribed penalty for personal bankruptcy and in social insurance policies when borrowing limits may respond to these changes. It uses a dynamic general equilibrium model of an exchange economy with incomplete markets and a continuum of agents. The borrowing constraint and the risk of default are endogenous, and the default penalty restricts an individual's access to the markets for a fixed period of time. The effect on the stationary equilibrium of an exogenous reduction of 1 and 2 years in this exclusion period is explored quantitatively. For comparison purposes, the same experiment is carried out under the assumption made in related studies that the borrowing limit is fixed. A small welfare loss follows in either case. In contrast, in a small open economy, welfare may increase substantially but only if the borrowing constraint is endogenous. Similar results follow from an exogenous change in social policy that reduces individual income variability.