The welfare cost of excess volatility in incomplete markets with sunspots

• Main Author: Kang, Minwook
• Other Authors: School of Social Sciences
• Format: Article
• Language: English
• Published: 2021
• Subjects: Social sciences::Economic theory; Excess Volatility; Market Incompleteness
• Online Access: https://hdl.handle.net/10356/151357
• Institution: Nanyang Technological University

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.