WP 2014-01 Robust bubbles with mild penalties for default

AUTHOR: Florin Bidian

ABSTRACT. Limited enforcement of debt contracts and mild penalties for default can lead to low equilibrium interest rates, to ensure debt repayment. Low interest rates, in turn, create conditions for bubbles. I show that bubbles can arise as a substitute to private liquidity when the punishment for default is a permanent or a temporary interdiction to trade, and complement in this way the existing results for an interdiction to borrow as penalty for default (Hellwig and Lorenzoni 2009). The size of bubbles is jointly determined by agents' endogenous debt limits and interest rates, and is not comonotonic with the amount of risk sharing that takes place in dierent equilibria. Agents' endogenous debt limits are not necessarily more relaxed for agents with higher income.