A Simple Model of Multiple Equilibria Based on Risk

Universitat Pompeu Fabra, Economics Working Paper No. 407

53 Pages Posted: 27 Mar 2000

See all articles by James S. Costain

James S. Costain

Banco de España - Research Department

Abstract

This paper shows how risk may aggravate fluctuations in economies with imperfect insurance and multiple assets. A two period job matching model is studied, in which risk averse agents act both as workers and as entrepreneurs. They choose between two types of investment: one type is riskless, while the other is a risky activity that creates jobs.

Equilibrium is unique under full insurance. If investment is fully insured but unemployment risk is uninsured, the precautionary saving behavior dampens output fluctuations. However, if both investment and employment are uninsured, then an increase in unemployment gives agents an incentive to shift investment away from the risky asset, further increasing unemployment. This positive feedback may lead to multiple Pareto ranked equilibria. An overlapping generations version of the model may exhibit poverty traps or persistent multiplicity. Greater insurance is doubly beneficial in this context since it can both prevent multiplicity and promote risky investment. prudence, temperance, precautionary saving, portfolio choice

Keywords: multiple equilibria, imperfect insurance, matching,

JEL Classification: E32, E21, G11

Suggested Citation

Costain, James S., A Simple Model of Multiple Equilibria Based on Risk. Universitat Pompeu Fabra, Economics Working Paper No. 407, Available at SSRN: https://ssrn.com/abstract=199060 or http://dx.doi.org/10.2139/ssrn.199060

James S. Costain (Contact Author)

Banco de España - Research Department ( email )

Alcala 50
28014 Madrid
Spain

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