A microfoundation for incomplete security markets

Harold Cole and Narayana Kocherlakota

No 577, Working Papers from Federal Reserve Bank of Minneapolis

Abstract: We consider a simple environment in which individuals receive income shocks that are unobservable to others and can privately store resources. We show that this ability to privately store can undercut the ability to shift resources across individuals to the extent that the efficient allocation only involves consumption smoothing over time, as opposed to insurance (consumption smoothing over states) if the rate of return on savings is not too far below the rate of time preference, or, alternatively, if the worst possible outcome is sufficiently dire. We also show that unlike environments without unobservable storage, the symmetric efficient allocation is decentralizable through a competitive asset market in which individuals trade risk-free bonds among themselves.

Keywords: Securities (search for similar items in EconPapers)
Date: 1997
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