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Endogenous market incompleteness without market frictions: Dynamic suboptimality of competitive equilibrium in multiperiod overlapping generations economies

  • Henriksen, Espen
  • Spear, Stephen

In this paper, we show that within the set of stochastic three-period-lived OLG economies with productive assets (such as land), markets are necessarily sequentially incomplete, and agents in the model do not share risk optimally. We start by characterizing perfect risk-sharing and find that it requires state-dependent consumption claims which depend only on the exogenous shock realizations. We show then that the recursive competitive equilibrium of any overlapping generations economy with weakly more than three generations is not strongly stationary. This then allows us to show directly that there are short-run Pareto improvements possible in terms of risk-sharing and hence, that the recursive competitive equilibrium is not Pareto optimal. We then show that a financial reform which eliminates the equity asset and replaces it with zero net supply insurance contracts (Arrow securities) will implement to Pareto optimal stochastic steady-state known to exist in the model. Finally, we also show via numerical simulations that a system of government taxes and transfers can lead to a Pareto improvement over the competitive equilibrium in the model.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 147 (2012)
Issue (Month): 2 ()
Pages: 426-449

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Handle: RePEc:eee:jetheo:v:147:y:2012:i:2:p:426-449
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622869

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  1. Chattopadhyay, Subir & Gottardi, Piero, 1999. "Stochastic OLG Models, Market Structure, and Optimality," Journal of Economic Theory, Elsevier, vol. 89(1), pages 21-67, November.
  2. Timothy J. Kehoe & David K. Levine, 1990. "The Economics of Indeterminacy in Overlapping Generations Models," Levine's Working Paper Archive 2193, David K. Levine.
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  9. Spear, Stephen E. & Srivastava, Sanjay, 1986. "Markov rational expectations equilibria in an overlapping generations model," Journal of Economic Theory, Elsevier, vol. 38(1), pages 35-62, February.
  10. Wang, P., 1991. "Money, Competitive Efficiency and Intergenerational Transactions," Papers 10-91-6, Pennsylvania State - Department of Economics.
  11. Peled, Dan, 1982. "Informational diversity over time and the optimality of monetary equilibria," Journal of Economic Theory, Elsevier, vol. 28(2), pages 255-274, December.
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  13. Duffie, Darrell, et al, 1994. "Stationary Markov Equilibria," Econometrica, Econometric Society, vol. 62(4), pages 745-81, July.
  14. Dirk Krueger & Felix Kubler, 2002. "Intergenerational Risk-Sharing via Social Security when Financial Markets Are Incomplete," American Economic Review, American Economic Association, vol. 92(2), pages 407-410, May.
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  16. Spear, Stephen E., 1985. "Rational expectations in the overlapping generations model," Journal of Economic Theory, Elsevier, vol. 35(2), pages 251-275, August.
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