Incomplete Markets, Growth, and the Business Cycle

Abstract

We introduce a Ramsey growth model with incomplete markets, decentralized production, and idiosyncratic technological risk. The combination of uninsurable shocks with the precautionary motive can slow down capital accumulation or give rise to persistent fluctuations even when agents are very patient and technology is strictly convex. The model generates closed-form expressions for the equilibrium dynamics under a finite or infinite horizon. Multiple steady states and poverty traps can arise from the endogeneity of the interest rate instead of the usual wealth effect. Depending on the economy's parameters, the local dynamics around a steady state are locally unique, totally unstable or locally undetermined, and the equilibrium path can be attracted to a limit cycle. In calibrated examples, financial incompleteness substantially slows down convergence to the steady state and thus increases the persistence of aggregate shocks.