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Recursive macroeconomic theory, Thomas Sargent 2nd Ed - Chapter 20

Chapter 20 Equilibrium without Commitment 20.1. Two-sided lack of commitment In section 19.3 of the previous chapter, we studied insurance without commitment. That was a partial equilibrium analysis since the moneylender could borrow or lend resources outside of the village at a given interest rate. | Chapter 20 Equilibrium without Commitment 20.1. Two-sided lack of commitment In section 19.3 of the previous chapter we studied insurance without commitment. That was a partial equilibrium analysis since the moneylender could borrow or lend resources outside of the village at a given interest rate. Recall also the asymmetry in the environment where villagers could not make any commitments while the moneylender was assumed to be able to commit. We will now study a closed system without access to an outside credit market. Any household s consumption in excess of its own endowment must then come from the endowments of the other households in the economy. We will also adopt the symmetric assumption that everyone is unable to make commitments. That is any contract prescribing an exchange of goods today in anticipation of future exchanges of goods represents a sustainable allocation only if both current and future exchanges are incentive compatible to all households involved in the contractual arrangement. Households are free to walk away from the arrangement at any point in time and to defect into autarky. Such a contract design problem with participation constraints on both sides of an exchange represents a problem with two-sided lack of commitment as compared to the problem with one-sided lack of commitment in section 19.3. This chapter draws upon the work of Thomas and Worrall 1988 and Kocherlakota 1996b . At the end of the chapter we also discuss market arrangements for decentralizing the constrained Pareto optimal allocation as studied by Kehoe and Levine 1993 and Alvarez and Jermann 2000 . - 692 - A closed system 693 20.2. A closed system Thomas and Worrall s 1988 model of self-enforcing wage contracts is an antecedent to our villager-money lender environment. The counterpart to our money lender in their model is a risk-neutral firm that forms a long-term relationship with a risk-averse worker. In their model there is also a competitive spot market for labor where