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Investment and Insurance in an Economic Union

  • Emilio Espino

    (Universidad Torcuato Di Tella)

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.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 1176.

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Date of creation: 2012
Date of revision:
Handle: RePEc:red:sed012:1176
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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  1. Aubhik Khan & B. Ravikumar, 1998. "Growth and Risk-Sharing with Private Information," Macroeconomics 9802003, EconWPA.
  2. Matthias Doepke & Robert M. Townsend, 2002. "Dynamic Mechanism Design With Hidden Income and Hidden Actions," UCLA Economics Working Papers 818, UCLA Department of Economics.
  3. 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.
  4. Gian Luca Clementi & Thomas Cooley & Sonia Di Giannatale, 2008. "A Theory of Firm Decline," Working Paper Series 33-08, The Rimini Centre for Economic Analysis, revised Jan 2008.
  5. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, vol. 54(4), pages 599-617, October.
  6. Mele, Antonio, 2010. "Repeated moral hazard and recursive Lagrangeans," MPRA Paper 21741, University Library of Munich, Germany.
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