Discussion Paper Details

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Title: Endogenous Market Incompleteness with Investment Risks

Author(s): Césaire A. Meh and Vincenzo Quadrini

Publication Date: December 2004

Keyword(s): Aggregate Capital, Asymmetric Information and optimal contracts

Programme Area(s): International Macroeconomics

Abstract: This Paper studies a general equilibrium economy in which agents have the ability to invest in a risky technology. The investment risk cannot be fully insured with optimal contracts because shocks are private information. We show that the presence of investment risks leads to under-accumulation of capital relative to an economy where idiosyncratic shocks can be fully insured. We also show that the availability of state-contingent (optimal) contracts ? compared to simple debt contracts ? brings the aggregate stock of capital close to the complete markets level. Institutional reforms that make possible the use of these contracts have important welfare consequences.

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Bibliographic Reference

Meh, C and Quadrini, V. 2004. 'Endogenous Market Incompleteness with Investment Risks'. London, Centre for Economic Policy Research.