Borrowing Constraint as an Optimal Contract

Grochulski, Borys and Zhang, Yuzhe (2009): Borrowing Constraint as an Optimal Contract.

Abstract

We study a continuous-time version of the optimal risk-sharing problem with one-sided commitment. In the optimal contract, the agent's consumption is non-decreasing and depends only on the maximal level of the agent's income realized to date. In the complete-markets implementation of the optimal contract, the Alvarez-Jermann solvency constraints take the form of a simple borrowing constraint familiar from the Bewley-Aiyagari incomplete-markets models. Unlike in the incomplete-markets models, however, the asset buffer stock held by the agent is negatively correlated with income.

• Item Type: MPRA Paper
• Language: English
• Keywords: Borrowing constraint, limited commitment
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D86 - Economics of Contract: Theory; D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D52 - Incomplete Markets

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