Consumer Default and the Life Cycle Model

This paper studies the impact of a default option on life-cycle consumption. Using a two period life-cycle model with uncertain income, the paper demonstrates that a default option causes a kink in both the budget set and the indifference curve at the point where the individual switches from saving to borrowing. This nonconvexity can have a dramatic impact on optimal consumption. The paper also explores the circumstances under which liquidity constraints are likely to emerge and the characteristics of those borrowers who are likely to face constraints. Copyright 1995 by Ohio State University Press.