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ASSET PRICES AND BUSINESS CYCLES UNDER LIMITED COMMITMENT

Juha Seppala ()

No 319, Computing in Economics and Finance 2000 from Society for Computational Economics

Abstract: This paper presents a business-cycle model with heterogeneous agents that have access to complete markets but face endogenous borrowing and savings constraints. These constraints are motivated by the agents' limited commitment technology. In this environment, aggregate fluctuations are close to the ones generated by Pareto Optimal (full commitment) risk-sharing arrangements. However, endogenous borrowing and savings constraints force agents to underinvest in capital and increase the volatilities of both the stochastic discount factor and the price of equity. The mechanism explains simultaneously both high average returns on equity and low average returns on bonds. This is accomplished in the economy with relatively small exogenous shocks and a high degree of patience, and a low degree of risk-aversion on the part of the agents. Previous work on limited commitment has concentrated on endowment economies and has emphasized borrowing constraints. Numerical results in this paper suggest that when capital is added to such models, savings constraints play even more central role.

Date: 2000-07-05
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