Endogenous Trading Constraints with Incomplete Asset Markets

Abstract

This paper endogenizes the borrowing constraints on capital holdings in an infinite horizon incomplete markets model with production and idiosyncratic risk. In particular, it assumes that households can break their trading arrangements by going into financial autarky, in which case they are excluded from future asset trade. We study the economy with the loosest possible borrowing limits that prevent default in equilibrium. We find that these limits are significantly different from zero, which is the ad hoc value often assumed in the literature. Further, they get looser with a higher labor income, consistent with US data on credit limits. The analysis of the welfare effects of a revenue neutral tax reform also illustrates that it is very important to take into account the direct effects of tax policies and the indirect effects of capital accumulation on the credit limits, since they can have quantitatively important welfare implications.