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A microfoundation for incomplete security markets

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  • Harold L. Cole
  • Narayana R. Kocherlakota

Abstract

We consider a simple environment in which individuals receive income shocks that are unobservable to others and can privately store resources. We show that this ability to privately store can undercut the ability to shift resources across individuals to the extent that the efficient allocation only involves consumption smoothing over time, as opposed to insurance (consumption smoothing over states) if the rate of return on savings is not too far below the rate of time preference, or, alternatively, if the worst possible outcome is sufficiently dire. We also show that unlike environments without unobservable storage, the symmetric efficient allocation is decentralizable through a competitive asset market in which individuals trade risk-free bonds among themselves.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Minneapolis in its series Working Papers with number 577.

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Date of creation: 1997
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Handle: RePEc:fip:fedmwp:577

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Keywords: Securities;

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Cited by:
  1. Khan, A. & Ravikumar, B., 1997. "Growth and Risk-Sharing with Private Information," Working Papers 97-13, University of Iowa, Department of Economics.
  2. Per Krusell & Anthony A. Smith, Jr., . "On the Welfare Effects of Eliminating Business Cycles," GSIA Working Papers 243, Carnegie Mellon University, Tepper School of Business.

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