Endogenous Credit Constraints and Household Portfolio Choices

Abstract

In this paper we develop a consumption and portfolio selection model for a household with borrowing constraints endogenized by limited enforcement of debt repayment. By using a duality approach, we provide explicit solutions for endogenous credit limits and consumption and portfolio policies. We derive theoretical implications for unsecured credit limits. Most noteworthy is the finding that a better investment opportunity implied by a higher Sharpe ratio increases the shares of investment in risky assets of the rich but decreases the shares of the poor. This is due to changes in credit limits according to a change in the Sharpe ratio. We also provide empirical evidence for our theoretical results by using the Survey of Consumer Finances.