Macroeconomics in the Small and the Large

Macroeconomics in the Small and the Large

Essays on Microfoundations, Macroeconomic Applications and Economic History in Honor of Axel Leijonhufvud

Edited by Roger E.A. Farmer

This book honors the work of Axel Leijonhufvud. The topics range from Keynesian economics and the economics of high inflation to the micro-foundations of macroeconomics and economic history. The authors comprise some of the very best economists active today.

Chapter 5:  Bankruptcy and Collateral in Debt Constrained Markets

Timothy J. Kehoe and David K. Levine

Subjects: economics and finance, economic psychology, financial economics and regulation, money and banking


5. Bankruptcy and collateral in debt constrained markets Timothy J. Kehoe and David K. Levine* The absence of private information implies that no consumer actually goes bankrupt in equilibrium: the credit agency will never lend so much to consumers that they will choose bankruptcy. This is very unlike . . . incomplete markets bankruptcy models. (Kehoe and Levine 2001) 5.1 INTRODUCTION: ‘A FOOLISH CONSISTENCY IS THE HOBGOBLIN OF LITTLE MINDS’1 General equilibrium models of bankruptcy have generally taken the perspective that bankruptcy is observed in the world, and so general equilibrium models should attempt to account for it. This point of view is very much in the spirit of the incomplete markets models on which these models are based. The theoretical literature on equilibria with incomplete markets and bankruptcy includes Araujo et al. (2002), Dubey et al. (1995), Dubey et al. (1989), Geanakoplos and Zame (2002), Kubler and Schmedders, (2003), Orrillo (2002) and Zame (1993). Recently papers by Chatterjee et al. (2004) and Livshits et al. (2003) have constructed models with incomplete markets and bankruptcy, calibrated them to data, and used them to address policy issues. These models only partially address some fundamental questions: Why should bankruptcy be allowed? What underlying economic fundamentals lead to particular types of bankruptcy? The enforcement constraint models of Kehoe and Levine (1993, 2001) and others attempt to answer the question of why we observe incomplete markets for insurance. The answer given is that not all profitable transactions can be carried out because some would violate the...

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