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Does Market Incompleteness Matter?

David K. Levine and William R. Zame

September 8, 1998

Revised: December 23, 1998

Abstract: Does incompleteness of intertemporal financial markets have significant consequences for the allocation of resources, for social welfare, or for prices? Intuition suggests that it should: incompleteness of intertemporal financial markets entails missing insurance markets, missing insurance markets entail imperfect risk sharing, imperfect risk sharing entails a loss of social welfare. Simple two-period models confirm this intuition --- but two-period models ignore the possibility that, in a long-horizon setting, patient traders could compensate for missing insurance markets by borrowing in bad times and repaying in good times. We argue here that market incompleteness will not matter much provided that individual shocks are transitory, time horizons are long, traders are patient, aggregate risk is traded and relative price effects are not important.We show by counterexample that when these conditions fail, market incompleteness may matter a great deal.