Incomplete markets and volatility (Q5945729)

In this paper Saving, Precaution, and Endogenous Cycles (SPEC) are treated. SPEC shows, that the precautionary motive, combined with asset incompleteness is a leading source of volatility and indeterminacy in the financial markets. This is shown by calculating the equilibrium path of a CARA normal economy with real assets and heterogeneous income streams. Price fluctuations originate from agent's efforts to ensure themselves through time by borrowing and lending instead of shifting income across states of nature by trading risk assets. A high interest rate at the future date reduces the potential for future consumption smoothing via borrowing, which leads to a strong precautionary motive and a low interest rate in the current period. The negative feedback between future and current rates generates fluctuations. When there is a intermediate level of market incompleteness and sufficient investor impatience, fluctuations in the real interest rate can be large, even though the aggregate endowment is constant. SPEC has a unique equilibrium under a finite horizon. Furthermore, there exists a robust continuum of equilibria that are neither bubbles nor sunspots, with a finite number of infinite lived agents.