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THE WELFARE COST OF EXCESS VOLATILITY IN INCOMPLETE MARKETS WITH SUNSPOTS

Published online by Cambridge University Press:  27 April 2017

Minwook Kang
Minwook Kang*
Affiliation:
Nanyang Technological University
*
Address correspondence to: Minwook Kang, Nanyang Technological University, 14 Nanyang Drive, HSS 04-58, Singapore 637332, Singapore; e-mail: [email protected]
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Abstract

In an incomplete markets economy with sunspots, the Pareto-criterion cannot rank sunspot equilibria of different levels of excess price-level volatility. Therefore, I propose a measure of excess volatility cost in terms of a period-0 endowment good. Ex-ante endowment subsidies are provided, in theory, to each consumer, so that the resulting equilibrium allocation of the higher volatility is Pareto-equivalent to the original benchmark equilibrium with a lower volatility level. The aggregate volatility cost is computed as the sum of all consumers' subsidies. Focusing on local analysis that considers small variations around a given volatility level, I show that the aggregate cost strictly increases in volatility even though each individual cost does not necessarily have this property.

Keywords

Excess VolatilityMarket IncompletenessPrice-Level VolatilitySunspotsWelfare Cost
Type
Articles
Information
Macroeconomic Dynamics , Volume 23 , Issue 3 , April 2019 , pp. 1062 - 1073
Copyright
Copyright © Cambridge University Press 2017 

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Footnotes

I appreciate helpful comments from Karl Shell, Larry Selden, Lei Sandy Ye, and two anonymous referees. I thank Peng Yudan and Ton My Linh for research assistance. I gratefully acknowledges research support from Nanyang Technological University (NTU) Start-up Grant and AcRF Tier-1 Grant (RG171/14).

References

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