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A microfoundation for incomplete security markets


  • Harold L. Cole
  • Narayana R. Kocherlakota


We consider a simple environment in which individuals receive income shocks that are unobservable to others and can privately store resources. We show that this ability to privately store can undercut the ability to shift resources across individuals to the extent that the efficient allocation only involves consumption smoothing over time, as opposed to insurance (consumption smoothing over states) if the rate of return on savings is not too far below the rate of time preference, or, alternatively, if the worst possible outcome is sufficiently dire. We also show that unlike environments without unobservable storage, the symmetric efficient allocation is decentralizable through a competitive asset market in which individuals trade risk-free bonds among themselves.

Suggested Citation

  • Harold L. Cole & Narayana R. Kocherlakota, 1997. "A microfoundation for incomplete security markets," Working Papers 577, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmwp:577

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    References listed on IDEAS

    1. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    2. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
    3. Edward J. Green & Ping Lin, 2000. "Diamond and Dybvig's classic theory of financial intermediation : what's missing?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-13.
    4. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
    5. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
    6. Neil Wallace, 1988. "Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 3-16.
    7. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
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    Cited by:

    1. Khan, Aubhik & Ravikumar, B., 2001. "Growth and risk-sharing with private information," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 499-521, June.
    2. Per Krusell & Anthony A. Smith, Jr., 1999. "On the Welfare Effects of Eliminating Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(1), pages 245-272, January.

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