Quantitative Economics: Jul, 2012, Volume 3, Issue 2

Rising indebtedness and temptation: A welfare analysis

Makoto Nakajima

Is the observed large increase in consumer indebtedness since 1970 beneficial for
U.S. consumers? This paper quantitatively investigates the macroeconomic and
welfare implications of relaxing borrowing constraints using a model with prefer-
ences featuring temptation and self-control. The model can capture two contrast-
ing views: the positive view, which links increased indebtedness to financial inno-
vation and thus better consumption smoothing, and the negative view, which is
associated with consumers’ overborrowing. I find that the latter is sizable: the cal-
ibrated model implies a social welfare loss equivalent to a 0.4 percent decrease in
per-period consumption from the relaxed borrowing constraint consistent with
the observed increase in indebtedness. The welfare implication is strikingly dif-
ferent from the standard model without temptation, which implies a welfare gain
of 0.7 percent, even though the two models are observationally similar. Although
both models imply welfare gains from a tighter borrowing limit than in 2000s, the
optimal borrowing limit is tighter according to the temptation model, as a tighter
borrowing limit helps consumers avoiding overborrowing.
Keywords. Temptation, self-control, hyperbolic discounting, overborrowing,
heterogeneous agents, general equilibrium.
JEL classification. D91, E21, E44, G18.

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