Costly intermediation and consumption smoothing

This paper studies quantitatively how intermediation costs affect household consumption loans and welfare. Agents face uninsurable idiosyncratic shocks to labor productivity in a production economy with costly financial intermediation and a borrowing limit. Reducing intermediation costs has two effects: (1) For a given decrease in the interest rate on borrowing, agents' ability to smooth consumption over time improves. (2) The demand for loans increases, which increases the interest rate. The net welfare gain of reducing intermediation costs from 3.927% (U.S. level) to 1% is about 1.14% of equivalent consumption in the baseline economy for an endogenous interest rate and 1.90% for an exogenous interest rate. The gains are distributed unevenly: households at the bottom wealth decile improve welfare by 3.96% and 5.86% of equivalent consumption, while those at the top decile have welfare gains of 0.35% and 0.2%, respectively. Sufficiently high intermediation costs eliminate borrowing and hence the welfare gain of reducing costs is not substantial. The welfare analysis includes transitional dynamics between steady states. © 2012 Western Economic Association International.