Incomplete Markets, Transitory Shocks, and Welfare

Although equilibrium allocations in models with incomplete markets are generally not Pareto-efficient, it is often argued that quantitative welfare losses from missing assets are small when time horizons are long and shocks are transitory. In this paper we use a computational analysis to show that even in the simplest infinite horizon model without aggregate uncertainty welfare losses can be substantial. Furthermore we show that in this model welfare losses from incomplete markets do not necessarily disappear when one considers calibrations of the model in which agents become very patient. We argue that when the economic model is calibrated to higher frequency data, the period persistence of negative income shocks must increase as well. In this case the welfare loss of incomplete markets remains constant even as agents' rate of time preference tends to one.