Defaults, Shortsales and the Social Costs of Volatility

This paper examines the welfare effects of credit and shortsales constraints and limited liability/minimum consumption guarantee in an overlapping generations (OLG) model with rational beliefs in the sense of Kurz (1994). To measure the social welfare, it instead adopts an ex post social welfare concept in the sense of Hammond (1981), since the standard Pareto criterion becomes inappropriate when heterogeneous beliefs are present. Simulation results indicate a trade-off between a larger opportunity set and a larger room for ‘mistakes’, and thus, the existence of a socially optimal level of various constraints.