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    1. Antunes: Departamento de Estudos Económicos, Banco de Portugal, Av. Almirante Reis 71, Lisbon 1150-012, Portugal. Phone 351 213128246, Fax 351 213128114, E-mail
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    1. Cavalcanti: Faculty of Economics, University of Cambridge and PIMES/UFPE, Sidgwick Avenue, Cambridge CB3 9DD, UK. Phone 44 1 223 335262, Fax 44 1 223 335475, E-mail
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    1. Villamil: Department of Economics and Finance, University of Illinois Urbana-Champaign and University of Manchester, 1407 South Gregory Street, Urbana, IL 61801. Phone 1 217 244 6330, Fax 1 217 244 6571, E-mail
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    • We thank the associate editor, Gian Luca Clementi, two anonymous referees, Kartik Athreya, Gabriele Camera, Dean Corbae, Jonathan Heathcote, Hashem Pesaran, Facundo Piguillem, Drew Saunders, Gustavo Ventura, and Rui Zhao for comments, and Rui Castro for conversations about computing the model transitional dynamics. We also benefited from comments at the SED Meeting, European Economic Association Congress, Latin American and Caribbean Department of the World Bank, IMT Institute for Advanced Studies in Lucca, Cambridge Finance Workshop, Purdue University, University of Iowa, and the University of Illinois. Villamil thanks the Said School of Business at the University of Oxford where she was the Peter Moores Fellow. Financial support from Fundação para a Ciência and Tecnologia, grant PTDC/EGE-ECO/108858/2008, is gratefully acknowledged. We are responsible for any remaining errors.


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. (JEL D91, E60, G38)