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Incomplete Markets, Transitory Shocks, and Welfare

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Author Info
Felix Kubler (Stanford University)
Karl Schmedders (Northwestern University)

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Abstract

Although equilibrium allocations in models with incomplete markets are generally not Pareto-efficient, it is often argued that quantitative welfare losses from missing assets are small when time horizons are long and shocks are transitory. In this paper, we use a computational analysis to show that even in the simplest infinite horizon model without aggregate uncertainty welfare losses can be substantial. Furthermore we show that in this model welfare losses from incomplete markets do not necessarily disappear when one considers calibrations of the model in which agent become very patient. We argue that when the economic model is calibrated to higher frequency data, the period persistence of negative income shocks must increase as well. In this case the welfare loss of incomplete markets remains constant even as agents' rate of time preference tends to one. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1006/redy.2001.0134
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Publisher Info
Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 4 (2001)
Issue (Month): 4 (October)
Pages: 747-766
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Handle: RePEc:red:issued:v:4:y:2001:i:4:p:747-766

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Related research
Keywords: incomplete markets heterogeneous agents welfare loss persistent shocks.

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Find related papers by JEL classification:
D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
D60 - Microeconomics - - Welfare Economics - - - General

References listed on IDEAS
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    Other versions:
  2. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April. [Downloadable!] (restricted)
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  3. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June. [Downloadable!] (restricted)
    Other versions:
  4. Wouter J. Denhaan, 2000. "The Importance Of The Number Of Different Agents In A Heterogeneous Asset-Pricing Model," Computing in Economics and Finance 2000 349, Society for Computational Economics.
  5. David K. Levine & William Zame, 1996. "Debt Constraints and Equilibrium in Infinite Horizon Economies with Incomplete Markets," Levine's Working Paper Archive 1954, UCLA Department of Economics. [Downloadable!]
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  6. Abreu, Dilip & Milgrom, Paul & Pearce, David, 1991. "Information and Timing in Repeated Partnerships," Econometrica, Econometric Society, vol. 59(6), pages 1713-33, November. [Downloadable!] (restricted)
    Other versions:
  7. David K Levine & William R Zame, 2000. "Risk Sharing and Market Incompleteness," Levine's Working Paper Archive 2080, UCLA Department of Economics. [Downloadable!]
  8. Manuel Santos, 1998. "Numerical Solution of Dynamic Economic Models," Working Papers 9804, Centro de Investigacion Economica, ITAM.
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  10. Judd, Kenneth L. & Kubler, Felix & Schmedders, Karl, 2000. "Computing equilibria in infinite-horizon finance economies: The case of one asset," Journal of Economic Dynamics and Control, Elsevier, vol. 24(5-7), pages 1047-1078, June. [Downloadable!] (restricted)
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    Other versions:
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Josep Pijoan-Mas, 2006. "Precautionary Savings or Working Longer Hours?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(2), pages 326-352, April. [Downloadable!] (restricted)
    Other versions:
  2. Henry Kim & Jinill Kim & Robert Kollmann, 2005. "Applying Perturbation Methods to Incomplete Market Models with Exogenous Borrowing Constraints," Discussion Papers Series, Department of Economics, Tufts University 0504, Department of Economics, Tufts University. [Downloadable!]
  3. Juan-Carlos Cordoba, 2004. "Debt-Constraints or Incomplete Markets? A Decomposition of the Wealth and Consumption Inequality in the U.S," Macroeconomics 0404004, EconWPA. [Downloadable!]
    Other versions:
  4. Jinill Kim & Sunghyun Henry Kim & Andrew Levin, 2001. "Patience, persistence and welfare costs of incomplete markets in open economies," International Finance Discussion Papers 696, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  5. Giorgio Primiceri & Thijs van Rens, 2002. "Inequality over the Business Cycle: Estimating Income Risk Using Micro-Data on Consumption," Economics Working Papers 943, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2004. [Downloadable!]
    Other versions:
  6. Ahmet Akyol & Kartik Artheya, 2003. "Risky higher education and subsidies," Working Paper 03-02, Federal Reserve Bank of Richmond. [Downloadable!]
    Other versions:
  7. Chiaki Hara & James Huang & Christoph Kuzmics, 2006. "Efficient Risk-Sharing Rules with Heterogeneous Risk Attitudes and Background Risks," Working Papers 621, Kyoto University, Institute of Economic Research. [Downloadable!]
  8. Alexis Anagnostopoulos, 2004. "Potential Welfare Losses from Financial Autarky and Trade Sanctions," Economics Working Papers ECO2004/35, European University Institute. [Downloadable!]
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