Working Paper: CEPR ID: DP4807
Authors: Csaire A. Meh; Vincenzo Quadrini
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.
Keywords: aggregate capital; asymmetric information; optimal contracts
JEL Codes: D58; D82; E20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investment risks (G11) | Underaccumulation of capital (E22) |
| Optimal contract economy (D86) | Lower equilibrium risk-free interest rate (E43) |
| Bond economy (H74) | Lower equilibrium risk-free interest rate (E43) |
| Investment risks (G11) | Lower equilibrium risk-free interest rate (E43) |
| Optimal contracts (D86) | Closer capital accumulation levels to complete markets (G19) |
| Institutional reforms (O17) | Increase in aggregate capital stock (E22) |
| Institutional reforms (O17) | Increase in welfare (I38) |