Endogenous trading constraints with incomplete asset markets

The present paper endogeneizes the borrowing constraints on capital holdings in an infinite horizon incomplete markets model with capital accumulation. In particular, it assumes that two types of households can break their trading arrangements by going into financial autarky, in which case they are seized from any positive asset holdings and excluded from future asset trade forever. Since we show that default cannot be an equilibrium outcome with free entry into a competitive financial intermediation sector, the endogenous trading constraints are then chosen at the loosest possible level that prevents default in equilibrium. Our results show that these limits are significantly different from zero, which is the ad hoc value often introduced in the literature. Further, they are monotone in the aggregate capital stock, since a higher capital reduces the interest rate on the financial obligations and decreases the incentive to default. Finally, in contrast with the existing literature, the limits are non monotone in the idiosyncratic and aggregate shocks due to the presence of incomplete markets and capital accumulation effects.