DP11623 | Multiple Equilibria in Open Economy Models with Collateral Constraints: Overborrowing Revisited

Publication Date

11/10/2016

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Abstract

This paper establishes the existence of multiple equilibria in infinite-horizon open-economy models in which the value of tradable and nontradable endowments serves as collateral. In this environment, the economy displays self-fulfilling financial crises in which pessimistic views about the value of collateral induces agents to deleverage. The paper shows that under plausible calibrations, there exist equilibria with underborrowing. This result stands in contrast to the overborrowing result stressed in the related literature. Underborrowing emerges in the present context because in economies that are prone to self-fulfilling financial crises, individual agents engage in excessive precautionary savings as a way to self-insure.