Abstract

Abstract. How does bankruptcy protection affects household balance sheet adjustments and aggregate consumption when credit tightens? We analyze the aggregate dynamics in household deleveraging and consumption in model in which households can default on unsecured credit. There is trade-off between a beneficial insurance and negative creditworthiness effects. When credit tightens, we find that: (i) Consumers decrease new borrowing and may default on existing credit, resulting in deleveraging and a drop in aggregate consumption with important selection effects due to changes in the composition of borrowers. (ii) Consumption and welfare reductions are especially harsh for poor households. (iii) Bankruptcy costs lead to a drop in aggregate consumption on impact, and exclusion from the credit market reduces the ability to smooth implying a slower recovery. The 2005 BAPCPA reform made filing for bankruptcy more difficult, and we find that it worsened the negative effects of credit tightening on aggregate consumption and welfare.