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Bankruptcy and Collateral in Debt Constrained Markets

Staff Report 380 | Published October 1, 2006

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Timothy J. Kehoe Consultant, University of Minnesota, and National Bureau of Economic Research
David K. Levine Visiting Scholar
Bankruptcy and Collateral in Debt Constrained Markets


Typical models of bankruptcy and collateral rely on incomplete asset markets. In fact, bankruptcy and collateral add contingencies to asset markets. In some models, these contingencies can be used by consumers to achieve the same equilibrium allocations as in models with complete markets. In particular, the equilibrium allocation in the debt constrained model of Kehoe and Levine (2001) can be implemented in a model with bankruptcy and collateral. The equilibrium allocation is constrained efficient. Bankruptcy occurs when consumers receive low income shocks. The implementation of the debt constrained allocation in a model with bankruptcy and collateral is fragile in the sense of Leijonhufvud’s “corridor of stability,” however: If the environment changes, the equilibrium allocation is no longer constrained efficient.

Published in: _Macroeconomics in the Small and the Large: Essays on Microfoundations, Macroeconomic Applications, and Economic History in Honor of Axel Leijonhufvud_ (2008, pp. 99-114)