Incomplete markets, transitory shocks, and welfare

Felix Kubler, Karl Schmedders*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

6 Scopus citations

Abstract

Although equilibrium allocations in models with incomplete markets are generally not Pareto-efficient, it is often argued that quantitative welfare losses from missing assets are small when time horizons are long and shocks are transitory. In this paper we use a computational analysis to show that even in the simplest infinite horizon model without aggregate uncertainty welfare losses can be substantial. Furthermore we show that in this model welfare losses from incomplete markets do not necessarily disappear when one considers calibrations of the model in which agents become very patient. We argue that when the economic model is calibrated to higher frequency data, the period persistence of negative income shocks must increase as well. In this case the welfare loss of incomplete markets remains constant even as agents' rate of time preference tends to one. Journal of Economic Literature Classification Numbers: D52, D58, D60.

Original languageEnglish (US)
Pages (from-to)747-766
Number of pages20
JournalReview of Economic Dynamics
Volume4
Issue number4
DOIs
StatePublished - 2001

Keywords

  • Heterogeneous agents
  • Incomplete markets
  • Persistent shocks
  • Welfare loss

ASJC Scopus subject areas

  • Economics and Econometrics

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