Private Information and Business Cycle Risk Sharing

Abstract

When individuals have private information about their own luck and income, the sharing of idiosyncratic risks is hampered by moral hazard. This friction also affects the optimal sharing of business cycle risks. Optimal allocations restrict the exposure of low wealth agents’ consumption to business cycle risk. This encourages truth-telling by high wealth agents who have a high tolerance for business cycle risk, thereby increasing the extent to which idiosyncratic risks can be shared. Implementation of these optimal allocations requires restrictions in the trade of securities contingent on business cycle outcomes.

Keywords: Incomplete markets, business cycles, distribution.

JEL Classification: D31, D52, D82.