Consumer default and optimal consumption decisions

Abstract

We examine the optimal consumption decisions of households in a micro-founded framework that assumes two financial frictions: heterogeneity between borrowing and saving households, and endogenous default. We study default in the context of two-period overlapping processes of consumer behavior, assuming that penalty costs are imposed on borrowers if they are delinquent in the first period and are subsequently refinanced by banks. The utility function of borrowing households is specified to include a term reflecting strategic decisions as regards non-payment of debt. From the solution of the household optimization problem, we derive an augmented Euler equation for consumption, which is a function inter alia of an expected default factor. We use this equation to calculate in a static equilibrium the optimal value of the percentage of debt repaid. We finally provide an ordering by size of the household discount factor: borrowers who do not repay all of their loans have the lowest discount factor, followed in turn by borrowers who fully repay them and by savers