Title

Default and Efficiency in a General Equilibrium Model with Incomplete Markets

Document Type

Discussion Paper

Publication Date

7-1-1988

CFDP Number

879R

CFDP Revision Date

1989-02-01

CFDP Pages

37

Abstract

We extend the standard model of general equilibrium with incomplete markets (GEI) to allow for default. Default can be either strategic, or due to ill-fortune. Agents who default are penalized to a degree proportional to the size of their default and to penalty parameters lambda. We find that under conditions similar to those necessary to guarantee the existence of GEI equilibrium, we get the existence of GEI λ equilibrium, for any λ > 0. We argue that default is thus reasonably modeled as an equilibrium phenomenon. Moreover, we show that more lenient lambda which encourage default may be Pareto improving because they allow for better risk spreading. When default occurs, the Modigliani-Miller theorem typically fails to hold in our framework.

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