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Investment and Insurance in an Economic Union

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  • Emilio Espino

    (Universidad Torcuato Di Tella)

Abstract

The presence of private information limits the extent of risk sharing in an economic union. Studying the optimal dynamic arrangement with these impediments is particularly important because of its potential effect on investment and the distribution of power between its members. This paper studies this problem in a neoclassical growth model with two countries. One of the countries faces "demand" shocks that are privately observed. The economic union must decide how much help they should provide to this country and how to finance those transfers: Should they come from a reduction of investment or of consumption of the other member? Importantly, the viability of the Economic Union may be at risk if private information imposes large welfare losses. To address these questions, an alternative recursive method to solve for the optimal allocation in this context is developed. The results suggest that, in spite of private information, it is still (constrained) optimal to provide some insurance but at the cost of a reduction in the welfare of the country helped. The welfare costs of private information are non-monotone in the size of the country with private information.

Suggested Citation

  • Emilio Espino, 2012. "Investment and Insurance in an Economic Union," 2012 Meeting Papers 1176, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:1176
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    File URL: https://economicdynamics.org/meetpapers/2012/paper_1176.pdf
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    References listed on IDEAS

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    1. Espino, Emilio, 2005. "On Ramsey's conjecture: efficient allocations in the neoclassical growth model with private information," Journal of Economic Theory, Elsevier, vol. 121(2), pages 192-213, April.
    2. Gian Luca Clementi & Thomas Cooley & Sonia Di Giannatale, 2010. "A Theory of Firm Decline," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 13(4), pages 861-885, October.
    3. Doepke, Matthias & Townsend, Robert M., 2006. "Dynamic mechanism design with hidden income and hidden actions," Journal of Economic Theory, Elsevier, vol. 126(1), pages 235-285, January.
    4. Khan, Aubhik & Ravikumar, B., 2001. "Growth and risk-sharing with private information," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 499-521, June.
    5. Thomas, Jonathan & Worrall, Tim, 1990. "Income fluctuation and asymmetric information: An example of a repeated principal-agent problem," Journal of Economic Theory, Elsevier, vol. 51(2), pages 367-390, August.
    6. Mele, Antonio, 2014. "Repeated moral hazard and recursive Lagrangeans," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 69-85.
    7. Stephen E. Spear & Sanjay Srivastava, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Oxford University Press, vol. 54(4), pages 599-617.
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