05-ce - Viktor Tsyrennikov Graduate Macroeconomics Complete...

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Unformatted text preview: Viktor Tsyrennikov Graduate Macroeconomics Complete Financial Markets So far we have assumed that agents individuals or households can trade only one asset. This asset was a credit bank account. It could also be thought of as risk-free debt. In a deterministic environment having a bank account balance was enough to achieve a consumption stream that was insensitive to current income fluctuations. That is the prescription of the permanent income hypothesis. Fluctuations of current income were translated into fluc- tuations in the bank account balance but not consumption. In a stochastic case having a bank account balance was not good enough fluctuations in current income translated into fluctuations in both bank account balance and consumption. We saw that an agents inability to guarantee oneself a deter- ministic consumption led him to accumulation of extra funds precautionary savings. In this section we study the role of the financial markets in gener- ating such a stark difference in outcomes between the two environments. We will allow for a rich set of financial assets in fact, as rich as it is possible so-called complete financial markets. This allows us to achieve three goals we set for this section. First, the competitive equilibrium al- location under complete financial markets coincides with the choice made by a social planner. Because of this complete markets models are a useful economic benchmark. We will use this to compute the welfare cost of the business/economic cycles. Second, we will develop consumption-based asset pricing theory that can be easily tested using the available aggregate data. Third, we study firms financing decisions and the celebrated Modigliani- Miller theorem. Throughout this section we will find that the economic equilibrium falls short of its ideal. So, at the end of the section we study an economy plagued by contract enforcement problems. This friction allows bringing the model closer to reality in all respects. Finally, we will make heavy use of the recursive approach. Not only it 1 Viktor Tsyrennikov Graduate Macroeconomics will make formulation of economic models easier but it will also allow us an easy computation of an equilibrium. 1 Description of an economy We are now equipped with enough knowledge of stochastic processes to get back to economics. So, now we learn how to specify a model of the economy. We continue studying endowment economies. This means that we do not care how the income in the economy is produced. (If we did, that would be an economy with production.) An economy is characterized by the following list: 1. Time Time is discrete and indexed by t { , 1 , 2 , ... } ....
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05-ce - Viktor Tsyrennikov Graduate Macroeconomics Complete...

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