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Credit card debt and default over the life-cycle

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This paper solves an empirically parameterised model of life-cycle consumption which extends the precautionary savings models of Carroll (1997), and Deaton (1991), to allow for uncollaterized borrowing and default. In case households choose to default: (i) their access to credit markets is restricted; (ii) lenders of funds may seize their financial assets above an exemption level, and up to the amount of outstanding debt; and (iii) there is a “stigma effect,” or a decrease in current utility caused by the social embarrassment of declaring bankruptcy. The model shows that the decisions to borrow and default are closely related to the shape of the life-cycle labor income profile, and henceforth vary across household education levels. Moreover, the model explains two puzzling empirical facts: (a) why bankruptcy rates have been growing in periods of economic expansion and low unemployment; and, (b) why households hold simultaneously high cost debt and low return assets.

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