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THE VALUE OF UNCERTAINTY UNDER LIMITED COMMITMENT

Published online by Cambridge University Press:  13 October 2014

Junichi Fujimoto
Junichi Fujimoto*
Affiliation:
University of Tokyo
*
New address—send correspondence to: Junichi Fujimoto, National Graduate Institute for Policy Studies (GRIPS), 7-22-1 Roppongi, Minato-ku, Tokyo 106-8677, Japan; e-mail: j-fujimoto@grips.ac.jp.
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Abstract

In this paper, I analyze an optimal loan contract between a risk-neutral financial intermediary and a risk-averse household, where the household receives a stochastic endowment stream that grows over time and is unable to commit to the contract. I examine the household's welfare in the equilibrium contract, and find that, first, under sufficiently rapid endowment growth, the presence of uncertainty in endowment may improve the household's welfare through relaxation of its commitment problem, and second, regardless of the endowment growth rate, the household's welfare is nonincreasing in the persistence of endowment. Numerical analysis suggests that welfare improvement from uncertainty may occur under reasonable parameters. These results have potentially important practical implications—for example, for developing countries that rely on external borrowing.

Keywords

Long-Term ContractsRisk SharingConsumption SmoothingLimited Commitment
Type
Articles
Information
Macroeconomic Dynamics , Volume 19 , Issue 8 , December 2015 , pp. 1715 - 1748
Copyright
Copyright © Cambridge University Press 2014 

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