Incomplete financial markets with real assets and wealth-dependent credit limits

Abstract In this paper we analyze the effects of restricted participation in a two-period general equilibrium model with incomplete financial markets and two key elements: the competitive trading of real assets, i.e., assets having payouts in terms of vectors of commodities, and household-specific inequality constraints that restrict participation in the financial markets. Similar to certain arrangements in the market for bank loans, household borrowing is restricted by a household-specific wealth dependent upper bound on credit lines in all states of uncertainty in the second period. We first establish that, generically in the set of the economies, equilibria exist and are finite and regular.We then show that equilibria are generically suboptimal. Finally, we provide a robust example demonstrating that the equilibrium allocations can be Pareto improved through a tightening of the participation constraints. This suggests, contrary to what is often cited as economic wisdom in the popular press, that in a setting with frictions resulting in an inefficient allocation the regulation of markets may have a Pareto-improving effect on the economy.