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Markov-Perfect Risk Sharing, Moral Hazard and Limited Commitment

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  • Alexander K. Karaivanov
  • Fernando M. Martin

Abstract

We define, characterize and compute Markov-perfect risk-sharing contracts in a dynamic stochastic economy with endogenous asset accumulation and simultaneous limited commitment and moral hazard frictions. We prove that Markov-perfect insurance contracts preserve standard properties of optimal insurance with private information and are not more restrictive than a long-term contract with one-sided commitment. Markov-perfect contracts imply a determinate asset time-path and a non-degenerate long-run stationary wealth distribution. We show numerically that Markov-perfect contracts provide sizably more consumption smoothing relative to self-insurance and that the welfare gains from resolving the commitment friction are larger than the gains from resolving the moral hazard friction at low asset levels, while the opposite holds for high asset levels.

Suggested Citation

  • Alexander K. Karaivanov & Fernando M. Martin, 2011. "Markov-Perfect Risk Sharing, Moral Hazard and Limited Commitment," Working Papers 2011-030, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:2011-030
    DOI: 10.20955/wp.2011.030
    Note: Original title: Moral hazard and lack of commitment in dynamic economies
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    1. Alexander Karaivanov & Fernando Martin, 2015. "Dynamic Optimal Insurance and Lack of Commitment," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(2), pages 287-305, April.
    2. Camilo Hern'andez & Dylan Possamai, 2023. "Time-inconsistent contract theory," Papers 2303.01601, arXiv.org.

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    More about this item

    Keywords

    Markov-perfect equilibrium; risk-sharing; limited commitment; moral hazard; consumption smoothing;
    All these keywords.

    JEL classification:

    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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