Rising indebtedness and temptation: a welfare analysis
Abstract: Is the observed large increase in consumer indebtedness since 1970 beneficial for U.S. consumers? This paper quantitatively investigates the macroeconomic and welfare implications of relaxing borrowing constraints using a model with preferences featuring temptation and self-control. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial innovation and thus better consumption smoothing, and the negative view, which is associated with consumers' over-borrowing. The author finds that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.4 percent decrease in per-period consumption from the relaxed borrowing constraint consistent with the observed increase in indebtedness. The welfare implication is strikingly different from the standard model without temptation, which implies a welfare gain of 0.7 percent, even though the two models are observationally similar. Naturally, the optimal level of the borrowing limit is significantly tighter according to the temptation model, as a tighter borrowing limit helps consumers by preventing over-borrowing.
Keywords: Equilibrium (Economics);
File(s): File format is application/pdf https://www.philadelphiafed.org/-/media/frbp/assets/working-papers/2011/wp11-39.pdf
Provider: Federal Reserve Bank of Philadelphia
Part of Series: Working Papers
Publication Date: 2011