Consumer Credit with Over-Optimistic Borrowers
- Author(s)
- Florian Exler, Igor Livshits, James MacGee, Michèle Tertilt
- Abstract
Do cognitive biases call for regulation to limit the use of credit? We incorporate over-optimistic and rational borrowers into an incomplete markets model with consumer bankruptcy. Over-optimists face worse income risk but incorrectly believe they are rational. Thus, both types behave identically. Lenders price loans forming beliefs-type scores-about borrower types. This gives rise to a tractable theory of type scoring. As lenders cannot screen types, borrowers are partially pooled. Over-optimists face cross-subsidized interest rates but make financial mistakes: borrowing too much and defaulting too little. In equilibrium, the welfare losses from mistakes are more than compensated by cross-subsidization. We calibrate the model to the US and quantitatively evaluate policies to address these frictions: financial literacy education, reducing default cost, increasing borrowing costs, and debt limits. While some policies lower debt and filings, only reducing default costs and financial literacy education improve welfare. However, financial literacy education benefits only rationals at the expense of over-optimists. Score-dependent borrowing limits can reduce financial mistakes but lower welfare.
- Organisation(s)
- Department of Economics
- External organisation(s)
- Federal Reserve Bank of Philadelphia, Bank of Canada, Universität Mannheim
- Journal
- Journal of the European Economic Association
- ISSN
- 1542-4766
- DOI
- https://doi.org/10.1093/jeea/jvae057
- Publication date
- 12-2024
- Peer reviewed
- Yes
- Austrian Fields of Science 2012
- 502018 Macroeconomics, 502009 Corporate finance
- Portal url
- https://ucrisportal.univie.ac.at/en/publications/f6ab7140-c625-4fd9-9a3a-2078a71a0336