DP4807 Endogenous Market Incompleteness with Investment Risks

Author(s): Césaire A. Meh, Vincenzo Quadrini
Publication Date: December 2004
Keyword(s): Aggregate Capital, Asymmetric Information, optimal contracts
JEL(s): D58, D82, E20
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4807

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.