Quantitative Economics: Jul, 2012, Volume 3, Issue 2
Rising indebtedness and temptation: A welfare analysis
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 prefer-
ences featuring temptation and self-control. The model can capture two contrast-
ing views: the positive view, which links increased indebtedness to financial inno-
vation and thus better consumption smoothing, and the negative view, which is
associated with consumers’ overborrowing. I find that the latter is sizable: the cal-
ibrated 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 dif-
ferent from the standard model without temptation, which implies a welfare gain
of 0.7 percent, even though the two models are observationally similar. Although
both models imply welfare gains from a tighter borrowing limit than in 2000s, the
optimal borrowing limit is tighter according to the temptation model, as a tighter
borrowing limit helps consumers avoiding overborrowing.
Keywords. Temptation, self-control, hyperbolic discounting, overborrowing,
heterogeneous agents, general equilibrium.
JEL classification. D91, E21, E44, G18.
Supplement to "Rising indebtedness and temptation: A welfare analysis"