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Endogenous Credit Limits with Small Default Costs

We analyze an exchange economy of unsecured credit where borrowers have the option to declare bankruptcy in which case they are temporarily excluded from financial markets. Endogenous credit limits are imposed that are just tight enough to prevent default. Economies with temporary exclusion differ from their permanent exclusion counterparts in two important properties. If households are extremely patient, then the first–best allocation is an equilibrium in the latter economies but not necessarily in the former. In addition, temporary exclusion permits multiple stationary equilibria, with both complete and with incomplete consumption smoothing.

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