Aggregate risk sharing and equivalent financial mechanisms in an endowment economy of incomplete participation

Summary. A pure endowment overlapping generations economy can be inefficient because of insufficient risk sharing. The introduction of an outside asset by a government or the existence of a clearing house can remedy the inefficiency by allowing some intergenerational risk sharing. While the typical outside asset is fiat money, many alternative financial mechanisms, such as social security, risk-free government bonds, mispriced deposit insurance, and income insurance can serve the same function as fiat money. Hence there are many equivalent financial mechanisms that provide intergenerational insurance. In the presence of uncertainty, there are several concepts of Pareto optimality that can be appropriately applied in an overlapping generations setting. I examine the risk-sharing arrangements associated with two different concepts of optimality, including how these arrangements are financed. The results are related to, and in some instances an extension of, the equivalence results obtained by Chamley and Polemarcharkis (1984), Weiss (1977), and Wallace (1981).Received: 4 March 2003, Revised: 30 January 2004JEL Classification Numbers: E40, E44, D51.P. Labadie: I would like to thank the participants of the Economic Theory Symposium Recent Developments in Money and Finance at Purdue University, May 2-4, 2003 and an anonymous referee for comments on this version. I am grateful to Bruce Smith for comments on an earlier version.