Price Theory for Incomplete Markets

Emmanuel Farhi, Alan Olivi () and Iván Werning

No 30037, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We provide a price theory for incomplete markets that extends the traditional Walrasian analysis. We derive formulas expressing the consumption response to current and future changes in interest rates and income. Our analysis provides a natural decomposition of these responses into substitution and income effects with structural interpretation, emphasizing statistics such as the marginal propensity to save and local measures of prudence in utility. We handle general uncertainty in a compact and intuitive manner by adjusting probability distributions: a risk-adjusted probability, commonly used in finance, and a novel prudence-adjusted probability, specifically useful for incomplete markets. Our formulas reveal various cross-restrictions implied by the theory on consumer behavior. Numerical explorations show that the new statistics we identify matter significantly to understand aggregate demand in incomplete markets, beyond the impact of heterogeneous marginal propensities to consume or binding borrowing constraints.

JEL-codes: D1 D52 (search for similar items in EconPapers)
Date: 2022-05
New Economics Papers: this item is included in nep-mac and nep-upt
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