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Incomplete Markets, Transitory Shocks And Welfare

Author

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  • Felix Kubler

    (Stanford University)

  • Karl Schmedders

    (Northwestern University)

Abstract

Equilibrium allocations in models with incomplete markets are generally not Pareto-efficient, but some argue that the welfare losses from missing assets are small when time-horizons are long, agents are patient, and shocks are transitory. We show that even in the simplest infinite horizon model without aggregate uncertainty welfare losses can be substantial and do not disappear when agents become more patient. Our argument has two parts. First, we argue that in dynamic models the persistence of income shocks should increase when the length of a period in the model decreases. This is necessary to maintain realistic properties for the serial correlation in annual income. We show computationally that in this case, the welfare losses from incomplete markets remain constant even as we reduce the model period. Second, we reexamine the analysis in Levine and Zame (1999). They claim that the incomplete market welfare converges to the complete market welfare as the discount factor converges to one. We show that this critically relies on their implicit assumptions regarding debt constraints, and that there is no convergence with more realistic debt constraint assumptions.

Suggested Citation

  • Felix Kubler & Karl Schmedders, 2000. "Incomplete Markets, Transitory Shocks And Welfare," Computing in Economics and Finance 2000 130, Society for Computational Economics.
  • Handle: RePEc:sce:scecf0:130
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Akyol, Ahmet & Athreya, Kartik, 2005. "Risky higher education and subsidies," Journal of Economic Dynamics and Control, Elsevier, vol. 29(6), pages 979-1023, June.
    2. Juan-Carlos Cordoba, 2004. "Debt-Constraints or Incomplete Markets? A Decomposition of the Wealth and Consumption Inequality in the U.S," Econometric Society 2004 Latin American Meetings 335, Econometric Society.
    3. Mr. Tom Krebs & Mr. Pravin Krishna & Mr. William Maloney, 2013. "Income Mobility and Welfare," IMF Working Papers 2013/024, International Monetary Fund.
    4. Kim, Jinill & Kim, Sunghyun Henry & Levin, Andrew, 2003. "Patience, persistence, and welfare costs of incomplete markets in open economies," Journal of International Economics, Elsevier, vol. 61(2), pages 385-396, December.
    5. Krebs, Tom & Krishna, Pravin & Maloney, William F., 2012. "Income Risk, Income Mobility and Welfare," IZA Discussion Papers 7056, Institute of Labor Economics (IZA).
    6. Heathcote, Jonathan & Storesletten, Kjetil & Violante, Giovanni L., 2008. "Insurance and opportunities: A welfare analysis of labor market risk," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 501-525, April.
    7. Josep Pijoan-Mas, 2006. "Precautionary Savings or Working Longer Hours?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(2), pages 326-352, April.
    8. Chiaki Hara & James Huang & Christoph Kuzmics, 2006. "Efficient Risk-Sharing Rules with Heterogeneous Risk Attitudes and Background Risks," KIER Working Papers 621, Kyoto University, Institute of Economic Research.
    9. Lee, Khang Min & Moyen, Nathalie, 2006. "Optimal liberalization of financial markets," Journal of International Money and Finance, Elsevier, vol. 25(8), pages 1319-1335, December.
    10. David K. Levine & William R. Zame, 2002. "Does Market Incompleteness Matter?," Econometrica, Econometric Society, vol. 70(5), pages 1805-1839, September.
    11. Piero Gottardi & Felix Kubler, 2015. "Dynamic Competitive Economies with Complete Markets and Collateral Constraints," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 82(3), pages 1119-1153.
    12. Henry Kim & Jinill Kim & Robert Kollmann, 2005. "Applying Perturbation Methods to Incomplete Market Models with Exogenous Borrowing Constraints," Discussion Papers Series, Department of Economics, Tufts University 0504, Department of Economics, Tufts University.
    13. Giuseppe Ambrosini & Francesco Menoncin, 2018. "Optimal Portfolios with Credit Default Swaps," Journal of Financial Services Research, Springer;Western Finance Association, vol. 54(1), pages 81-109, August.
    14. Giorgio Primiceri & Thijs van Rens, 2002. "Inequality over the business cycle: Estimating income risk using micro-data on consumption," Economics Working Papers 943, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2004.

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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D60 - Microeconomics - - Welfare Economics - - - General

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