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Incompleteness Shocks

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  • Eduardo Davila

    (New York University)

  • Thomas Philippon

    (New York University)

Abstract

This paper studies the effects of shocks to the degree of market completeness. We present a dynamic stochastic economy where agents can trade in complete markets in normal times, but where financial markets can stochastically become incomplete. When this happens, agents cannot trade in state contingent assets and cannot re-hedge their risks. Our model formalizes a new type of purely financial shock, which we call an incompleteness shock. Even if we allow our agents to hedge the incompleteness shock itself, we find that these shocks are sufficient to trigger a recession with misallocation of capital, lower aggregate output, and consumption. Our results imply that financial market disruptions will unavoidably generate a recession, even if they are perfectly anticipated and agents can freely reallocate resources ex-ante.

Suggested Citation

  • Eduardo Davila & Thomas Philippon, 2018. "Incompleteness Shocks," 2018 Meeting Papers 109, Society for Economic Dynamics.
    • Handle: RePEc:red:sed018:109
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    References listed on IDEAS

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    Cited by:

    1. Vuillemey, Guillaume, 2018. "Completing Markets with Contracts: Evidence from the First Central Clearing Counterparty," CEPR Discussion Papers 13230, C.E.P.R. Discussion Papers.

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