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Price Theory for Incomplete Markets

Author

Listed:
  • Emmanuel Farhi
  • Alan Olivi
  • Iván Werning

Abstract

We provide a price theory for incomplete markets that extends the traditional Walrasian analysis. We derive formulas expressing the consumption response to current and future changes in interest rates and income. Our analysis provides a natural decomposition of these responses into substitution and income effects with structural interpretation, emphasizing statistics such as the marginal propensity to save and local measures of prudence in utility. We handle general uncertainty in a compact and intuitive manner by adjusting probability distributions: a risk-adjusted probability, commonly used in finance, and a novel prudence-adjusted probability, specifically useful for incomplete markets. Our formulas reveal various cross-restrictions implied by the theory on consumer behavior. Numerical explorations show that the new statistics we identify matter significantly to understand aggregate demand in incomplete markets, beyond the impact of heterogeneous marginal propensities to consume or binding borrowing constraints.

Suggested Citation

  • Emmanuel Farhi & Alan Olivi & Iván Werning, 2022. "Price Theory for Incomplete Markets," NBER Working Papers 30037, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:30037
    Note: EFG
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    More about this item

    JEL classification:

    • D1 - Microeconomics - - Household Behavior
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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