Optimal exclusion

In a canonical model of borrowing and lending, an exclusion technology that features full exclusion for a deterministic number of periods following default maximizes stationary equilibrium welfare. This exclusion policy maximizes the stationary volume of mutually beneficial lending transactions. It also maximizes the average welfare of the excluded. The optimal length of exclusion depends on fundamentals such as borrower patience and the direct cost of default. It also depends on incentives to default for strategic rather than exogenous reasons.