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When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and when is it not)?

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Dirk Krueger
Hanno Lustig

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Abstract

In a standard incomplete markets model with a continuum of households that have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In the equilibrium, which features trade and binding solvency constraints, as opposed to Constantinides and Duffie (1996), households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore we show that the cross-sectional wealth and consumption distributions are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, and arise even when households face tight solvency constraints, but only a weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12634.

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Date of creation: Oct 2006
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Handle: RePEc:nbr:nberwo:12634

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Find related papers by JEL classification:
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
G0 - Financial Economics - - General

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  1. YiLi Chien & Harold Cole & Hanno Lustig, 2007. "A Multiplier Approach to Understanding the Macro Implications of Household Finance," NBER Working Papers 13555, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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