Date of Original Version

11-7-2006

Type

Working Paper

Rights Management

All Rights Reserved

Abstract or Description

The question we ask is: within the set of a three-period-lived OLG economies with a stochastic endowment process, a stochastic dividend process, and sequentially incomplete complete markets, under what set of conditions may a set of government transfers dynamically Pareto dominate the laissez faire equilibrium? We start by characterizing perfect risk sharing and find that it implies a strongly stationary set of state-dependent consumption claims. We also derive the stochastic equivalent of the deterministic steady-state by steady-state optimal marginal rate of substitution. We show then that the risk sharing of the recursive competitive laissez faire equilibrium of any overlapping generations economy with weakly more than three generations is nonstationary and that risk is suboptimally shared. We then show that we can construct a sequence of consumption allocations that only depends on the exogenous state and which Pareto dominate the laissez faire allocations in an ex interim as well as ex ante sense. We also redefine conditional Pareto optimality to apply within this framework and show that under a broad set of conditions, there also exists a sequence of allocations that dominates the laissez faire equilibrium in this sense. Finally, we apply these tools and results to an economy where the endowment is constant, but where fertility is stochastic, i.e. the number of newborn individuals who enters the economy follows a Markov Process.

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