Advanced Macroeconomics

Final Exam Review Session

Rui Mascarenhas*

December 10, 2019

1 Consumer bankruptcy

1.1 Intuition
In our usual models, we assume that consumers do not default on their debts. When a
household sells a bond, it does so with full commitment to its repayment the period of
maturity, and not fulfilling its obligations is never an option they can take. This is one of
the simplifications we make in order to study other aspects of the macroeconomy.
However, in reality, US law establishes legal procedures for the case in which agents
do default on their outstanding debts. In particular, Chapter 7 of the U.S. bankruptcy
code states circumstances in which debtors can discharge their financial obligations. We
want to figure out whether, from a macroeconomic standpoint, this legal framework is a
good idea; to do so, we must evaluate its benefits and costs.
The benefits of consumer bankruptcy laws accrue to households. They establish that
households who suffer adverse shocks to their income and wealth don’t need to be sad-
dled with huge debt for the rest of their lives – in a sense, providing them with insurance
against these bad states of nature. The costs to consumer bankruptcy arise because fi-
nancial intermediaries (the lenders) internalize that some of their assets might have zero
value if the debtors are able to default. As such, to keep from realizing losses on their
portfolio, they demand higher interest rates, which in turn impedes some borrowers from
fully smoothing their consumption over time.
* Columbia University. All typos are my own. Questions/comments/typos: rdm2158@columbia.edu.

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1.2 Setup
1.2.1 Households and shocks

Households maximize single good utility function each period, appropriately discounted:

J
X
β j−1 u(c)
j=1

At each age j, they get labor income yj :

yj = zj ηj ēj

Here, zj represents a persistent shock to labor income, which follows a Markov chain
Π(z 0 |z). ηj represents an i.i.d. transitory shock to income. Households also may have
to spend some of their income each period in an i.i.d. expense shock κ > 0 with some
probability π. These shocks will drive some agents to declare bankruptcy1 .
Households can save and borrow through a one-period bond with face value of re-
payment d (d > 0 means borrowing – positive debt). This debt will have a price of q b ,
which can differ depending on the value of the debt but also on the current permanent
productivity shock and on the households’ age: q b = q b (d, z, j). Each loan costs τ to the
intermediary, which realizes zero expected profits due to perfect competition. This zero
profit competition pins down the price of loans q b .

1.2.2 Bankruptcy law

At the beginning of the period, the shocks are realized and the household has repayment
obligations of d + κ. It then decides whether to file for bankruptcy or not. If it does, then
their debts are cancelled. However, bankruptcy law establishes that some of its earnings
must be garnished and transferred to creditor: more concretely, households lose γy of
their income. Moreover, in the next period, bankrupt agents are prevented from saving
or borrowing, so they are forced to consume (1 − γ)y in that period.
We further assume that bankruptcy cannot be declared two periods in a row, which
prevents households from continually reneging on their debts. This mirrors the key fea-
tures of Chapter 7: legally, households can only declare bankruptcy once every six years.
1
See here for an example.

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1.3 Consumer problem
The consumer’s problem has a recursive structure, where they will try to maximize their
value functions. Since there are three separate states an agent can choose to be in – repay-
ing debts, declaring bankruptcy for all debts and not paying κ after bankruptcy – we will
need three different value functions.

1.3.1 Repaying one’s debts

The value of repaying one’s debts is given by V :

Vj (d, z, η, κ) = max
0
u(c) + βE max{Vj+1 (d0 , z 0 , η 0 , κ0 ), V̄j+1 (z 0 , η 0 )}
c,d

s.to c + d ≤ ēj zη + q b (d0 , z, j)d0 − κ

Note that if an agent declares bankruptcy, it does not need to pay its obligations d0 + κ0
in the following period; hence, they do not show up in the next period value function
V̄j+1 .

1.3.2 Declaring bankruptcy

The value of declaring bankruptcy is given by V̄ :

V̄j (z, η) = u((1 − γ)zηēj ) + βE max{Vj+1 (0, z 0 , η 0 , κ0 ), W̄j+1 (z 0 , η 0 , κ0 )}

In this state, the household eats its earnings after forfeiting γ to creditors, and starts
the next period with d = 0. It still might pay the unexpected expense κ, but it can choose
whether to do so immediately or to have it as the debt for the period after.

1.3.3 Delaying payment on unexpected expenses

The value of delating payment on κ is given by W̄ :

W̄j (z, η, κ) = u((1 − γ)zηēj ) + βE max Vj+1 (d0 , z 0 , η 0 , κ0 ) , V̄j+1 (z 0 , η 0 )



with
d0 = (κ − γēj zη)(1 + r)

In this state, the household can choose to pay its debts, which are given by the expense
shock net of the garnished income. If it does so, it faces V in the following period; if it
doesn’t, it declares bankruptcy and faces V̄ in the following period.

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1.4 The rest of the model
1.4.1 The intermediary problem

First, define I(d + κ, z, η) ∈ {0, 1} as the decision of a household aged-j with debts d + κ
and state η, z to default or not. If I = 0, then the household does not default; if I = 1, it
defaults on its debt.
For an intermediary to make zero profit, the price of a bond with some default prob-
ability must be different than the price of a bond with zero default probability (unless
the first probability is zero). Call the price of a riskless bond q̄ b , and the probability of a
household (d0 , z, j) defaulting by θ(d0 , z, j).
With probability 1 − θ, the household does not default and the intermediary can price
as if it were a riskless bond: q̄ b . With probability θ, the household defaults and the inter-
mediary only recovers the expected garnished income γzηēj . That is, it only gets back a
γzηē
proportion E( d0 +κj |I = 1) of the bond’s value. We therefore have the price of the bond
yielding zero profit must be
 
b 0 0 b 0 γzηēj
q (d , z, j) = (1 − θ (d , z, j)) q̄ + θ (d , z, j) E |I = 1 q̄ b
d0 + κ0

1.4.2 Equilibrium

In equilibrium, the value of bankruptcy does not depend on the current debt level, and
the value of repaying falls as the debt gets larger. Therefore, the optimal decision rule for
a given household should be to repay if the debt is not too large and to default otherwise.
That is, there should be a threshold value d¯j (z, η) such that the household is indifferent
between repaying and defaulting:

¯ z, η, 0) = V̄j (z, η)
Vj (d,

which means that households default as long as d¯ ≥ d + κ.

1.4.3 Taking the model to the data

When we calibrate this model to replicate the fraction of households declaring bankruptcy
and the average borrowing interest rate, it performs fairly well. It also predicts lower
earnings for bankrupt households than the average, and the concurrence of negative ex-
pense shocks with bankruptcy.

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2 Review questions
Note: Even if you couldn’t make it to the review session, you should be able to get the answers for
these questions with the help of lecture slides and recitation notes.

1. What is the impact of greater wage bargaining power for workers on the wage rate?

2. What happens to the Beveridge curve if matching between workers and firms be-
comes easier (for given unemployment and vacancy rates)?

3. Describe the source of inefficiency in the cash-in-advance model.

4. Why is money useful in the overlapping generations model?

5. Why is the suspension arrangement in the bank run model incentive compatible?

6. What is the expected return in a bank run equilibrium, and why is it undesirable?

7. Why should stocks offer a higher return than risk-free bonds?

8. Describe the aggregate economic costs and benefits of Chapter 7 bankruptcy laws.