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Incomplete Markets, Transitory Shocks And Welfare

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  • Felix Kubler

    (Stanford University)

  • Karl Schmedders

    (Northwestern University)

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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Bibliographic 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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  1. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  2. 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.
  3. 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.
  4. 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.
  5. Magill,Michael & Quinzii,Martine, 1992. "Infinite horizon,Incomplete markets," Discussion Paper Serie A 384, University of Bonn, Germany.
  6. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  7. David K. Levine & William Zame, 2001. "Does Market Incompleteness Matter," Levine's Working Paper Archive 78, David K. Levine.
  8. 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.
  9. Manuel Santos, 1998. "Numerical Solution of Dynamic Economic Models," Working Papers 9804, Centro de Investigacion Economica, ITAM.
  10. 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.
  11. 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.
  12. 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.
  13. Michael Magill & Martine Quinzii, 2000. "Infinite horizon CAPM equilibrium," Economic Theory, Springer, vol. 15(1), pages 103-138.
  14. Abreu, Dilip & Milgrom, Paul & Pearce, David, 1991. "Information and Timing in Repeated Partnerships," Econometrica, Econometric Society, vol. 59(6), pages 1713-33, November.
  15. David K Levine & William R Zame, 2000. "Risk Sharing and Market Incompleteness," Levine's Working Paper Archive 2080, David K. Levine.
  16. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
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