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Working Papers

October 2019, No. 19-19

Debt Limits and Credit Bubbles in General Equilibrium

V. Filipe Martins-da-Rocha, Toan Phan and Yiannis Vailakis

We provide a novel characterization of self-enforcing debt limits in a general equilibrium framework of risk sharing with limited commitment, where defaulters are subject to recourse (a fractional loss of current and future endowments) and exclusion from future credit. We show that debt limits are exactly equal to the present value of recourse plus a credit bubble component. We provide applications to models of sovereign debt, private collateralized debt, and domestic public debt. Implications include an original equivalence mapping among distinct institutional arrangements, thereby clarifying the relationship between different enforcement mechanisms and the connection between asset and credit bubbles.

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