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Incomplete Markets, Transitory Shocks And Welfare

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Author Info
Felix Kubler (Stanford University)
Karl Schmedders (Northwestern University)

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Abstract

Equilibrium allocations in models with incomplete markets are generally not Pareto-efficient, but some argue that the welfare losses from missing assets are small when time-horizons are long, agents are patient, and shocks are transitory. We show that even in the simplest infinite horizon model without aggregate uncertainty welfare losses can be substantial and do not disappear when agents become more patient. Our argument has two parts. First, we argue that in dynamic models the persistence of income shocks should increase when the length of a period in the model decreases. This is necessary to maintain realistic properties for the serial correlation in annual income. We show computationally that in this case, the welfare losses from incomplete markets remain constant even as we reduce the model period. Second, we reexamine the analysis in Levine and Zame (1999). They claim that the incomplete market welfare converges to the complete market welfare as the discount factor converges to one. We show that this critically relies on their implicit assumptions regarding debt constraints, and that there is no convergence with more realistic debt constraint assumptions.

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Publisher Info
Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2000 with number 130.

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Date of creation: 05 Jul 2000
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Handle: RePEc:sce:scecf0:130

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Postal: CEF 2000, Departament d'Economia i Empresa, Universitat Pompeu Fabra, Ramon Trias Fargas, 25,27, 08005, Barcelona, Spain
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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. David K. Levine & William Zame, 2001. "Does Market Incompleteness Matter," Levine's Working Paper Archive 78, David K. Levine. [Downloadable!]
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  2. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April. [Downloadable!] (restricted)
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  3. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June. [Downloadable!] (restricted)
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  4. Wouter J. Denhaan, 2000. "The Importance Of The Number Of Different Agents In A Heterogeneous Asset-Pricing Model," Computing in Economics and Finance 2000 349, Society for Computational Economics.
  5. David K. Levine & William Zame, 1996. "Debt Constraints and Equilibrium in Infinite Horizon Economies with Incomplete Markets," Levine's Working Paper Archive 1954, David K. Levine. [Downloadable!]
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  6. Abreu, Dilip & Milgrom, Paul & Pearce, David, 1991. "Information and Timing in Repeated Partnerships," Econometrica, Econometric Society, vol. 59(6), pages 1713-33, November. [Downloadable!] (restricted)
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  7. David K Levine & William R Zame, 2000. "Risk Sharing and Market Incompleteness," Levine's Working Paper Archive 2080, David K. Levine. [Downloadable!]
  8. Manuel Santos, 1998. "Numerical Solution of Dynamic Economic Models," Working Papers 9804, Centro de Investigacion Economica, ITAM.
  9. Per Krusell & Anthony A. Smith & Jr., 1998. "Income and Wealth Heterogeneity in the Macroeconomy," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 867-896, October. [Downloadable!] (restricted)
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  10. Judd, Kenneth L. & Kubler, Felix & Schmedders, Karl, 2000. "Computing equilibria in infinite-horizon finance economies: The case of one asset," Journal of Economic Dynamics and Control, Elsevier, vol. 24(5-7), pages 1047-1078, June. [Downloadable!] (restricted)
  11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November. [Downloadable!] (restricted)
  12. Magill, Michael & Quinzii, Martine, 1994. "Infinite Horizon Incomplete Markets," Econometrica, Econometric Society, vol. 62(4), pages 853-80, July. [Downloadable!] (restricted)
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  13. van Wincoop, Eric, 1999. "How big are potential welfare gains from international risksharing?," Journal of International Economics, Elsevier, vol. 47(1), pages 109-135, February. [Downloadable!] (restricted)
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  14. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969. [Downloadable!] (restricted)
  15. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. David K. Levine & William Zame, 2001. "Does Market Incompleteness Matter," Levine's Working Paper Archive 78, David K. Levine. [Downloadable!]
    Other versions:
  2. Josep Pijoan-Mas, 2006. "Precautionary Savings or Working Longer Hours?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(2), pages 326-352, April. [Downloadable!] (restricted)
    Other versions:
  3. Henry Kim & Jinill Kim & Robert Kollmann, 2005. "Applying Perturbation Methods to Incomplete Market Models with Exogenous Borrowing Constraints," Discussion Papers Series, Department of Economics, Tufts University 0504, Department of Economics, Tufts University. [Downloadable!]
  4. Juan-Carlos Cordoba, 2004. "Debt-Constraints or Incomplete Markets? A Decomposition of the Wealth and Consumption Inequality in the U.S," Macroeconomics 0404004, EconWPA. [Downloadable!]
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  5. Jinill Kim & Sunghyun Henry Kim & Andrew Levin, 2001. "Patience, persistence and welfare costs of incomplete markets in open economies," International Finance Discussion Papers 696, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  6. Giorgio Primiceri & Thijs van Rens, 2002. "Inequality over the Business Cycle: Estimating Income Risk Using Micro-Data on Consumption," Economics Working Papers 943, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2004. [Downloadable!]
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  7. Ahmet Akyol & Kartik Artheya, 2003. "Risky higher education and subsidies," Working Paper 03-02, Federal Reserve Bank of Richmond. [Downloadable!]
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  8. Chiaki Hara & James Huang & Christoph Kuzmics, 2006. "Efficient Risk-Sharing Rules with Heterogeneous Risk Attitudes and Background Risks," KIER Working Papers 621, Kyoto University, Institute of Economic Research. [Downloadable!]
  9. Alexis Anagnostopoulos, 2004. "Potential Welfare Losses from Financial Autarky and Trade Sanctions," Economics Working Papers ECO2004/35, European University Institute. [Downloadable!]
  10. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2007. "Insurance and Opportunities: A Welfare Analysis of Labor Market Risk," NBER Working Papers 13673, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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