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Incomplete Markets and Volatility

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Author Info
Laurent E. Calvet

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Abstract

This paper shows that the precautionary motive, combined with asset incompleteness, is a major source of volatility and indeterminacy in financial markets. Price fluctuations originate from agents' efforts to insure themselves through time by borrowing and lending instead of shifting income across states of nature by trading in risky assets. A high interest rate at a future date reduces the potential for future consumption smoothing across time via borrowing, leading to a strong precautionary motive and a low interest rate in the current period. The negative feedback between future and current interest rates generates fluctuations. This logic is developed in SPEC, a CARA-normal model with many periods, risky time-dependent endowments, and endogenous interest rates. Unlike existing frameworks, SPEC allows us to analyze the effect of financial structure on temporal fluctuations along a given path. In equilibrium, individual consumption is random, but the macro variables are deterministic and vary through time. When there is an intermediate level of market incompleteness and sufficient investor impatience, fluctuations in the real interest rate can be large, even though the aggregate endowment is constant. SPEC has a unique equilibrium under a finite horizon; on the other hand, with a finite number of infinitely-lived agents, there exists a robust continuum of equilibria that are neither bubbles nor sunspots.

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Paper provided by Harvard - Institute of Economic Research in its series Harvard Institute of Economic Research Working Papers with number 1865.

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Date of creation: 1999
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Handle: RePEc:fth:harver:1865

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  1. George-Marios Angeletos & Laurent-Emmanuel Calvet, 2004. "Incomplete Market Dynamics in a Neoclassical Production Economy," NBER Working Papers 11016, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Djumashev, R, 2007. "Corruption, uncertainty and growth," MPRA Paper 3716, University Library of Munich, Germany. [Downloadable!]
  3. Raven Saks & Stephen Shore, 2005. "Risk and Career Choice," Advances in Economic Analysis & Policy, Berkeley Electronic Press, vol. 5(1), pages 1414-1414. [Downloadable!] (restricted)
  4. Chaiki Hara & Atsushi Kajii, 2004. "Risk-Free Bond Prices in Incomplete Markets with Recursive Utility Functions and Multiple Beliefs," KIER Working Papers 590, Kyoto University, Institute of Economic Research. [Downloadable!]
  5. David K. Levine & William Zame, 2001. "Does Market Incompleteness Matter," Levine's Working Paper Archive 78, David K. Levine. [Downloadable!]
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  6. Laurent Calvet & Martin Gonzalez-Eiras & Paolo Sodini, 2001. "Financial Innovation, Market Participation and Asset Prices," Harvard Institute of Economic Research Working Papers 1928, Harvard - Institute of Economic Research. [Downloadable!]
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  7. Ratbek Dzhumashev, 2007. "Corruption, Uncertainty And Growth," Monash Economics Working Papers 15/07, Monash University, Department of Economics. [Downloadable!]
  8. Laurent E. Calvet & Adlai J. Fisher, 2006. "Multifrequency Jump-Diffusions: An Equilibrium Approach," NBER Working Papers 12797, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Juan-Carlos Cordoba, 2004. "Debt-Constraints or Incomplete Markets? A Decomposition of the Wealth and Consumption Inequality in the U.S," Econometric Society 2004 Latin American Meetings 335, Econometric Society. [Downloadable!]
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  10. Tom Krebs, 2006. "Recursive equilibrium in endogenous growth models with incomplete markets," Economic Theory, Springer, vol. 29(3), pages 505-523, November. [Downloadable!] (restricted)
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  11. sunanda roy, 2005. "Asset prices and capital accumulation in a monetary economy with incomplete markets," GE, Growth, Math methods 0508002, EconWPA. [Downloadable!]
  12. George-Marios Angeletos & Laurent E. Calvet, 2001. "Incomplete Markets, Growth, and the Business Cycle," Harvard Institute of Economic Research Working Papers 1910, Harvard - Institute of Economic Research. [Downloadable!]
  13. Alessandro, CITANNA & SCHMEDDERS, Karl, 2002. "Controlling price volatility through financial innovation," Les Cahiers de Recherche 749, HEC Paris. [Downloadable!]
  14. Dzhumashev, Ratbek, 2008. "Corruption and Disposable Risk," MPRA Paper 11772, University Library of Munich, Germany. [Downloadable!]
  15. Carsten Krabbe Nielsen, 2004. "Stabilizing, Pareto Improving Policies in an OLG model with Incomplete Markets: The Rational Expectations and Rational Beliefs Case," Econometric Society 2004 Far Eastern Meetings 617, Econometric Society. [Downloadable!]
  16. George-Marios Angeletos & Laurent Calvet, 2003. "Idiosyncratic Production Risk, Growth, and the Business Cycle," NBER Working Papers 9764, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
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