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Financial Markets Incompleteness and Inequality Over the Life-Cycle

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  • Jaime Ruiz-Tagle

Abstract

This paper addresses the relevance of contemporary uncertainty under incomplete markets in explaining wealth and consumption inequality when preferences are homogeneous. We explore the role of illiquid saving (saving that cannot be used to buffer contemporary shocks) generated by contemporary uncertainty, and a cost of liquidating saving, in generating differences in saving behaviour between initially-rich and initially-poor in a numerically solved life-cycle model. We observe that the existence of a risk premium significantly increases the ability of the households to accumulate wealth to finance their consumption, even under high risk aversion. We find that there is increasing consumption inequality across the life-cycle between groups, and that this result is boosted by access to risky assets and higher values of the coefficient of risk aversion. Critically, the possibility to borrow against saving helps to prevent increased consumption inequality paths, which is the effect of illiquid saving under contemporary uncertainty. Our findings may help us to understand why the poor save so little, and therefore support social programmes that guarantee a minimum consumption for those below a certain level of wealth to allow them to catch up with wealthier individuals.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 405.

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Date of creation: Dec 2006
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Handle: RePEc:chb:bcchwp:405

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  1. Sule Alan, 2005. "Entry costs and stock market participation over the life cycle," IFS Working Papers W05/01, Institute for Fiscal Studies.
  2. Bodie, Zvi & Merton, Robert C. & Samuelson, William F., 1992. "Labor supply flexibility and portfolio choice in a life cycle model," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 427-449.
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  4. Richard Blundell & Ian Preston, 1998. "Consumption Inequality And Income Uncertainty," The Quarterly Journal of Economics, MIT Press, vol. 113(2), pages 603-640, May.
  5. Gomes, Francisco J & Michaelides, Alexander, 2005. "Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence," CEPR Discussion Papers 4853, C.E.P.R. Discussion Papers.
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  9. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  10. Bertaut, Carol C. & Haliassos, Michael, 1997. "Precautionary portfolio behavior from a life-cycle perspective," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1511-1542, June.
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  17. Attanasio, Orazio P & Weber, Guglielmo, 1995. "Is Consumption Growth Consistent with Intertemporal Optimization? Evidence from the Consumer Expenditure Survey," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1121-57, December.
  18. Quadrini, Vincenzo, 1999. "The Importance of Entrepreneurship for Wealth Concentration and Mobility," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 45(1), pages 1-19, March.
  19. Orazio Attanasio & Steven J. Davis, 1994. "Relative Wage Movements and the Distribution of Consumption," NBER Working Papers 4771, National Bureau of Economic Research, Inc.
  20. Alexander Michaelides & Francisco J. Gomes, 2005. "Optimal life cycle asset allocation : understanding the empirical evidence," LSE Research Online Documents on Economics 193, London School of Economics and Political Science, LSE Library.
  21. Gollier, Christian & Pratt, John W, 1996. "Risk Vulnerability and the Tempering Effect of Background Risk," Econometrica, Econometric Society, vol. 64(5), pages 1109-23, September.
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  24. Jonathan Skinner & Stephen P. Zeldes, 2002. "The Importance of Bequests and Life-Cycle Saving in Capital Accumulation: A New Answer," American Economic Review, American Economic Association, vol. 92(2), pages 274-278, May.
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  26. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
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Cited by:
  1. Nicoletta Batini & Douglas Laxton, 2006. "Under What Conditions Can Inflation Targeting Be Adopted? The Experience of Emerging Markets," Working Papers Central Bank of Chile 406, Central Bank of Chile.
  2. Pierpaolo Benigno & Michael Woodford, 2006. "Optimal Inflation Targeting Under Alternative Fiscal Regimes," Working Papers Central Bank of Chile 407, Central Bank of Chile.

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