Purpose – The authors examine the optimal consumption decisions of households in a micro-founded framework that introduces endogenous default. They study default in the context of a two-period process, assuming three non-overlapping steps of non-payment: delinquency, non-performing loans and bankruptcy (default).
Design/methodology/approach – In their model, the authors extend the analysis of loan default to two periods and include agent heterogeneity by considering also saving households. In the optimization problem, the authors obtain first-order conditions for borrowers who do not repay all of their loans (comparing them to those who fully repay them) and also for savers. In addition, by using nonlinear Generalized Method of
Moments (GMM), they obtain consistent estimates of the household preference parameters and present the impulse responses of borrowers’ consumption to demand shocks.
Findings – The authors derive an augmented consumption Euler equation for borrowers, which is a function inter alia of an expected default factor. They estimate this equation and find non-negligible differences in preference parameters relative to values reported in the literature. Further, an ordering by size of the household discount factors is provided empirically. Finally, the impulse responses of borrowers’ consumption to a demand
shock are found to last more for borrowers who do not fully repay their debts.
Originality/value – This work represents a promising line of research by introducing default in one of the basic components of DSGE models, making the latter more appropriate for analyzing monetary and macroprudential policies.