Preliminary and Incomplete Equilibrium in a Production Model with Limited Contract Enforcement

This paper develops a tractable macroeconomic model with production and limited commitment (limited enforceability of contracts). The paper provides a characterization of recursive equilibria that is independent of the (endogenous) wealth distribution, which implies that recursive equilibria can be computed solving a finite-dimensional fixed-point problem. The paper also shows that a calibrated version of the model is consistent with some important empirical facts about individual income and consumption. In particular, the model generates a random walk component in individual labor income and, for households with little financial wealth, a limited amount of individual consumption insurance. The quantitative analysis also shows that equilibrium risk sharing is highly sensitive to the degree of contract enforcement as measured by the amount of capital seized upon default. Department of Economics, University of Mannheim, L7,3-5, 68131 Mannheim, Germany. Department of Economics, University of California, Los Angeles, Box 951477, CA 90095.