Financial Markets Incompleteness and Inequality Over the Life-Cycle

This paper addresses the relevance of contemporary uncertainty under incomplete markets in explaining wealth and consumption inequality when preferences are homogeneous. We explore the role of illiquid saving (saving that cannot be used to buffer contemporary shocks) generated by contemporary uncertainty, and a cost of liquidating saving, in generating differences in saving behaviour between initially-rich and initially-poor in a numerically solved life-cycle model. We observe that the existence of a risk premium significantly increases the ability of the households to accumulate wealth to finance their consumption, even under high risk aversion. We find that there is increasing consumption inequality across the life-cycle between groups, and that this result is boosted by access to risky assets and higher values of the coefficient of risk aversion. Critically, the possibility to borrow against saving helps to prevent increased consumption inequality paths, which is the effect of illiquid saving under contemporary uncertainty. Our findings may help us to understand why the poor save so little, and therefore support social programmes that guarantee a minimum consumption for those below a certain level of wealth to allow them to catch up with wealthier individuals.