Bankruptcy and Transaction Costs in General Financial Models
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University of Pennsylvania ScholarlyCommons Publicly Accessible Penn Dissertations Spring 2010 Bankruptcy and Transaction Costs in General Financial Models Matthew Hoelle University of Pennsylvania, [email protected] Follow this and additional works at: https://repository.upenn.edu/edissertations Part of the Economic Theory Commons, and the Finance Commons Recommended Citation Hoelle, Matthew, "Bankruptcy and Transaction Costs in General Financial Models" (2010). Publicly Accessible Penn Dissertations. 119. https://repository.upenn.edu/edissertations/119 This paper is posted at ScholarlyCommons. https://repository.upenn.edu/edissertations/119 For more information, please contact [email protected]. Bankruptcy and Transaction Costs in General Financial Models Abstract General financial models have become workhorse models in the fields of macroeconomics and finance. These models have been developed and extensively studied by general equilibrium theorists. What makes them so applicable for macroeconomics and finance is the well accepted fact that models with a representative agent and without financial frictions yield equilibrium outcomes that are inconsistent with the empirical realities of financial markets. The general financial models are characterized by two main features: heterogeneous agents and financial frictions. The ability of these models ot be applied in the fields of macroeconomics and finance in the future depends upon the frontier research in general equilibrium today. Over the past 20 years, research in general equilibrium has predominantly focused on a single friction: incomplete financial markets. The papers contained in this dissertation will analyze the equilibrium effects, both positive and normative, of two seldom researched frictions: bankruptcy and transaction costs. It is the hope that by studying financial frictions in isolation, we may learn which frictions have the greatest effect on welfare, which frictions are most able to be controlled by the government, and how to satisfactorily analyze the equilibrium of a process that is concurrently being restrained by several frictions. Degree Type Dissertation Degree Name Doctor of Philosophy (PhD) Graduate Group Economics First Advisor Felix Kubler Second Advisor Dirk Krueger Third Advisor Andrew Postlewaite Keywords general equilibrium, GEI, bankruptcy, constrained suboptimality, proportional reimbursement Subject Categories Economic Theory | Finance This dissertation is available at ScholarlyCommons: https://repository.upenn.edu/edissertations/119 BANKRUPTCY AND TRANSACTION COSTS IN GENERAL FINANCIAL MODELS Matthew Hoelle A DISSERTATION in Economics Presented to the Faculties of the University of Pennsylvania in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy 2010 Supervisor of Dissertation Signature_________________________ Felix Kubler Professor, University of Zurich and Swiss Finance Institute Graduate Group Chairperson Signature_________________________ Dirk Krueger, Professor, Economics Dissertation Committee Felix Kubler, Professor, University of Zurich and Swiss Finance Institute Dirk Krueger, Professor, Economics Andrew Postlewaite, Professor, Economics Acknowledgement I would like to acknowledge the wonderful opportunity that I have been granted over my past 5 years at the University of Pennsylvania, including one year as a visiting scholar at the University of Zurich. This opportunity has allowed me to advance my education under the tutelage of some of the finest economists in the world. I will thank these individuals in turn, but first and foremost, I would never have had this opportunity if not for the loving support of my parents, Tom and Lydia. For their phone calls and interest in my research, I am grateful. This dissertation is dedicated to them. I would like to thank the late Dave Cass. His role as the ‘General’ and instructor of the most idiosyncratic first year GE course imaginable sparked my interest in the field. His insightful discussions and critiques helped me develop as a researcher. I would like to thank Felix Kubler. After serving as his teaching assistant for two semesters, I recognized that if I wanted to produce research in GE, he would be an invaluable person to have on my team. Following his move from the University of Pennsylvania to the University of Zurich, Felix was gracious enough to fund my one year visit to his new department, the Swiss Banking Institute. Working alongside Felix for one year, I was able to develop the papers that are contained in this dissertation. I would like to thank Dirk Krueger. He has certainly proved to be a helpful advisor for the macroeconomic applications of my research, but more importantly, Dirk was the Director of Graduate Studies (DGS) and approved my leave to the University of Zurich. His support for all graduate students regardless of their research endeavors certainly goes above and beyond his duties as DGS. ii I would like to thank Andrew Postlewaite for agreeing to serve on my committee and for many helpful discussions on bankruptcy and asymmetric information. I would like to thank Kelly Quinn at the University of Pennsylvania and Ruth Hafliger at the University of Zurich for their essential roles in providing administrative assistance, without which I would never have been able to navigate the daily life of a graduate student. I would like to thank my colleagues, especially my first-year study group of Cristiano Costa, Huanlei Ni, and Klenio Barbosa. It is often said that nourishment in the early years of one’s life has a larger impact than at any other time. As that first year of graduate school was when I began my academic life, the countless discussions and laughs shared with this group are, and will ever be, greatly impactful. Finally, I acknowledge financial support from the Fontaine Fellowship at the University of Pennsylvania and financial support from the Swiss Banking Institute at the University of Zurich. iii Abstract BANKRUPTCY AND TRANSACTION COSTS IN GENERAL FINANCIAL MODELS Matthew Hoelle Supervisor: Felix Kubler General financial models have become workhorse models in the fields of macroeconomics and finance. These models have been developed and extensively studied by general equilibrium theorists. What makes them so applicable for macroeconomics and finance is the well accepted fact that models with a representative agent and without financial frictions yield equilibrium outcomes that are inconsistent with the empirical realities of financial markets. The general financial models are characterized by two main features: heterogeneous agents and financial frictions. The ability of these models to be applied in the fields of macroeconomics and finance in the future depends upon the frontier research in general equilibrium today. Over the past 20 years, research in general equilibrium has predominantly focused on a single friction: incomplete financial markets. The papers contained in this dissertation will analyze the equilibrium effects, both positive and normative, of two seldom researched frictions: bankruptcy and transaction costs. It is the hope that by studying financial frictions in isolation, we may learn which frictions have the greatest effect on welfare, which frictions are most able to be controlled by the government, and how to satisfactorily analyze the equilibrium of a process that is concurrently being restrained by several frictions. iv Contents 1 Introduction 1 1.1 Bankruptcy in a 2-Period Model …………...…………………………... 11 1.2 Bankruptcy in an Infinite Horizon Model …………………………….... 16 1.3 Transaction Costs and Planner Intervention………………..…………... 20 1.4 References………………………………………………………………. 29 2 Bankruptcy in a 2-Period Model 32 2.1 Introduction…………………………………………………………….. 32 2.2 The Model……………………………………………………………… 37 2.2.1 Convexity………………………………………………….…… 40 2.2.2 Boundedness, bankrupt households………………………….… 42 2.2.3 Repayment rates………………………………………………… 45 2.2.4 Definition of bankruptcy equilibrium………………………….. 47 2.2.5 Boundedness, solvent households………………………………. 48 2.3 Absence of Chain Reactions…………………………………………..... 50 2.4 Real Costs of Bankruptcy………………………………………………. 57 2.5 Proof of Theorem 2.1…………………………………..……………….. 62 2.6 References……………………………………………………………… 69 3 Bankruptcy in an Infinite Horizon Model 71 3.1 Introduction……………………………………………………………... 71 3.2 The Model……………………………………………………………… 76 3.2.1 Primitives………………………………………………………. 77 v 3.2.2 Financial markets………………………………………………. 80 3.2.3 Bankruptcy assumptions………………………………………... 82 3.2.4 Bankruptcy equilibrium………………………………………… 84 3.3 Necessity of Private Information………………………………………. 93 3.4 Asset Prices Strictly Increasing in “Credit Score”……………………… 94 3.5 Conclusion……………………………………………………………… 98 3.6 Proofs…………………………………………………………………… 99 3.7 References………………………………………………………………. 124 4 Transaction Costs and Planner Intervention 127 4.1 Introduction……………………………………………………………... 127 4.2 The Model………………………………………………………………. 130 4.3 The Result………………………………………………………………. 146 4.4 Proofs of Lemmas………………………………………………………. 168 4.5 References………………………………………………………………. 173 vi Chapter 1 Introduction The models studied in the …eld of general equilibrium capture a trading environment in its purest form. Trades are both competitive and anonymous: competitive in that households can trade any amount of good or asset at the posted market price and anonymous in that households only adjust their trading decisions as the price changes and not based on who they trade with. It is these non-strategic interactions