Welfare of Incomplete Markets Economy with Permanent as well as Transitory Shocks

Abstract

Under the assumption that shocks are transitory, the welfare properties of the incomplete markets economy with only bonds are well known. As agents become more patient, its behavior get closer to that of the complete markets economy. As shocks become more persistent, the incomplete markets economy behave much differently from the complete markets economy. This paper shows that, when shocks have permanent as well as transitory components, neither of these two properties is true. More patience does not always move the incomplete markets economy closer to the complete markets economy, and more persistence in growth rate shocks induces similarity between the incomplete markets economy and the complete markets economy.