7
Competitive Equilibrium with Complete Markets
Time- 0 versus sequential trading
This chapter describes the competitive equilibrium for a pure exchange innite
horizon economy with stochastic Markov endowments. This economy is a basic
setting for studying risk sharing, asset pricing, and consumption. We describe
two market structures: the Arrow-Debreu structure with complete markets in
dated contingent claims all traded at time 0, and a recursive structure with
complete one-period Arrow securities. These two have dierent asset structures
and timings of trades, but lead to identical allocations of consumption across
people. Both are referred to as complete market economies. They allow more
comprehensive sharing of risks than do the incomplete markets economies to be
studied in chapters 13 and 14.
The physical setting
Preferences and endowments
Let (s0js) be a Markov chain with initial distribution 0 (s) given. That
is, Prob(st+1 = s0jst = s) = (s0js) and Prob(s0 = s) = 0 (s). As we saw in
chapter 1, the chain induces a sequence of probability measures (st) on histories
st = [st ; st 1 ; : : : ; s0 ] via the recursions
(st ) = (st jst 1 ) (st 1 jst 2 ) : : : (s1js0 )0 (s0 ):
(7:1)
Formula (7.1) is the unconditional probability of st when s0 has not been realized. If s0 has been observed, the appropriate distribution of st is conditional
on s0 , in which case we use
(st js0 ) = (st jst 1 ) (st 1 jst 2 ) : : : (s1 js0 ):
(7:2)
144
Chapter 7: Competitive Equilibrium with Complete Markets
In the rest of this chapter, we shall assume that trading occurs after s0 has been
observed, so we shall use equation (7.2). 1 Using our notation, (stjs ) is the
probability of state st conditional on being in state s at date ,
(st js ) = (st jst 1 ) (st 1 jst 2 ) : : : (s +1 js );
(7:3)
Because of the Markov assumption, (stjs ) does not depend on the history
s 1 .
There are I agents named i = 1; : : : ; I . Agent i owns a stochastic endowment
of one good yti = yi(st ) that depends on the realization of st . Note that yti is
a time invariant function of st . The variable st is publicly observable. Household i purchases a history-dependent consumption plan ci = fcit (st )g1
t=0 . The
household orders consumption streams by
U (ci ) =
1X
X
t=0 st
t u[cit (st )] (stjs0 )
(7:4)
t
i
where the right side is equal to E0 P1
t=0 u(ct ), where E0 is the mathematical
expectation operator, conditioned on s0 . Here u(c) is an increasing, twice continuously dierentiable, strictly concave function of consumption c of one good.
The utility function satises the Inada condition
lim
u0 (c) = +1:
c#0
Complete markets
Households trade dated state-contingent claims to consumption. There is a
complete set of securities. Trades occur at time 0, after s0 has been realized. The
household can exchange claims on time- t consumption, contingent on history st
at price qt0 (st). The superscript 0 refers to the date at which trades occur, while
the subscript t refers to the date that deliveries are to be made. The household's
budget constraint is
1X
X
t=0 st
qt (
0
st
) ( )
cit
st
1X
X
t=0 st
qt0 (st )y i (st ):
(7:5)
1 Most of our formulas carry over to the case where trading occurs before s0 has been realized;
just replace equation (7.2) with equation (7.1).
The physical setting
145
The household's problem is to choose ci to maximize expression (7.4) subject
inequality (7.5). Here qt0 is the price of time t consumption contingent on history
st at t in terms of an abstract unit of account or numeraire. Underlying the single
budget constraint (7.5) is thet fact that multilateral trades are possible through
a clearing operation that keeps track of net claims. 2 All trades occur at time 0.
After time 0, trades that were agreed to at 0 are executed.
For each consumer, there is a single budget constraint (7.5) to which we attach
a Lagrange multiplier i . We obtain the rst-order conditions for the household's
problem:
@U (ci )
= i qt0 (st):
(7:6)
@cit (st )
The left side is the derivative of total utility to the time- t , state- st component
of consumption. Each individual has his own i , which is independent of time.
Note also that with specication (7.4) of the utility functional, we have
@U (ci )
= t u0 [cit (st )](stjs0):
(7:7)
@cit (st )
This expression implies that equation (7.6) can be written
t u0 [cit (st )] (stjs0 ) = i qt0 (st ):
(7:8)
We use the following denitions:
A price system is a sequence of functions fqt0(st )g1
t=0 . An allocai
i
t
1
tion is a list of sequences of functions c = fct (s )gt=0 , one for each i . A feasible
allocation satises
X
X
y i (st ) cit (st ):
(7:9)
Definitions:
i
i
A competitive equilibrium is a feasible allocation and price system
such that the allocation solves each household's problem.
Notice that equation (7.8) implies
u0 [cit (st )] i
=
(7:10)
u0 [cjt (st )] j
Definition:
2 In the language of modern payments systems, this is a system with net settlements, not
gross settlements, of trades.
146
Chapter 7: Competitive Equilibrium with Complete Markets
for all pairs (i; j ). Thus, ratios of marginal utilities between pairs of agents are
constant across all states and dates.
An equilibrium allocation solves equations (7.10), (7.9), and (7.5). Note that
equation (7.10) implies that
cit
(
st
) = u0
1
i
u0 [c1t (st )] 1 :
(7:11)
Substituting this into equation (7.9) at equality gives
X
i
u0
1
i
u0 [c1t (st )] 1
=
X
i
y i (st ):
(7:12)
The right side of equation (7.12) depends only on the current st and not the
entire history st ; therefore, the left side, and so c1t (st ), must also depend only on
st . It follows from equation (7.11) that the equilibrium allocation cit (st ) depends
only on st for each i . We summarize this analysis in the following proposition:
The competitive equilibrium allocation is not history dependent; ( ) = (st ).
Proposition 1:
cit
st
ci
Equilibrium pricing function
Suppose that ci , i = 1; : : : ; I is an equilibrium allocation. Then the marginal
condition (7.6) or (7.8) gives the price system qt0 (st ) as a function of the allocation
to household i , for any i . Note that the price system is a stochastic process.
Because the units of the price system are arbitrary, one of the multipliers can be
normalized at any positive value. We shall set 1 = u0 [c1 (s0)], so that q00 (s0) = 1,
putting the price system in units of time-0 goods. 3
3 This choice also implies that i = u [ci (s0 )] for all i .
0
147
Examples
Examples
Risk sharing
Suppose that the one-period utility function is of the constant relative riskaversion form
u(c) = (1 ) 1 c1 ; > 0:
Then equation (7.10) implies
( ) =( )
cit
or
cjt
cit =
cjt
i
j
i 1
j
:
(7:13)
Equation (7.13) states that time- t elements of consumption allocations to distinct
agents are constant fractions of one another. With a power utility function,
it says that individual consumption is perfectly correlated with the aggregate
endowment or aggregate consumption. The fractions assigned to each individual
are independent of the realization of st . Thus, there is extensive cross-state and
cross-time consumption smoothing. The constant fractions characterization of
consumption comes from (1) complete markets and (2) a homothetic one-period
utility function.
No aggregate uncertainty
Let st be a Markov process taking values on the unit interval [0; 1]. There are
two households,
with yt1 = s and yt2 = 1 s . Note that the aggregate endowment
P i
is yt = i yt = 1. We use a guess-and-verify method to nd the equilibrium.
Guess that the equilibrium allocation satises cit = ci0 for all t for i = 1; 2. Then
from equation (7.8),
u0 (ci )
(7:14)
qt0 (st ) = t (st js0 ) i0 ;
for all t for i = 1; 2. Household i 's budget constraint implies
1X
u0 (ci0 ) X
t (st js ) ci
i (s ) = 0:
y
0
t
0
i t=0 st
148
Chapter 7: Competitive Equilibrium with Complete Markets
Solving this equation for ci0 gives
ci
0
= (1 )
1X
X
t=0 st
t (st js0 )y i (st ):
(7:15)
Summing equation (7.15) veries that c10 + c20 = 1.
Periodic endowment processes
Consider the special case of the previous example in which st is a twostate Markov chain taking the two values f0; 1g, with transition probabilities
(1j0) = (0j1) = 1, (0j0) = (1j1) = 0. Suppose that 0 (1) = 1, so that the
initial value of the shock s0 and therefore of the endowment y01 is 1. Thus, the
endowment processes are perfectly predictable sequences (1; 0; 1; : : :) for the rst
agent and (0; 1; 0; : : :) for the second agent. Let s~t be the history of (1; 0; 1; : : :)
up to t . Evidently, (~st) = 1, and the probability assigned to all other histories
up to t is zero. The equilibrium price system is then
qt (
0
st
t
st = s~t ;
) = 0; ; ifotherwise
;
when using the time-0 good as numeraire, q00(~s0) = 1. From equation (7.15), we
have
1
X
1 ;
1
c0 = (1 ) 2j =
(7:16a)
1+
j =0
c
2
0
= (1 )
1
X
j =0
2j =
1+:
(7:16b)
Consumer 1 consumes more every period because he is richer by virtue of receiving
his endowment earlier.
Interpretation of trading arrangement
In the competitive equilibrium, all trades occur at t = 0 in one market. Deliveries occur after t = 0, but no more trades. A vast credit system operates at
t = 0. An unspecied clearing system assures that condition (7.5) holds for each
household i . A symptom of the once-and-for-all trading arrangement is that each
Primer on asset pricing
149
household faces one budget constraint that accounts for all trades across dates
and states.
In a subsequent section, we describe another trading arrangement with more
trading dates but fewer securities at each date. As a prelude to that section,
we describe some asset-pricing implications embedded in the model with time-0
trading.
Primer on asset pricing
Many asset-pricing models assume complete markets and price assets by breaking an asset into a sequence of state-contingent claims, evaluating each component
of that sequence at the relevant \state price deator" q0t , then adding up those
values. The asset being priced is viewed as redundant, in the sense that it oers
a bundle of state-contingent dated claims, each component of which has already
been priced by the market. While we shall devote a later chapter entirely to
such asset-pricing theories, it is useful to give some pricing formulas at this point
because they help illustrate the complete market competitive structure.
Pricing redundant assets
t
Let fd(st)g1
t=0 be a stream of claims on time t , state s consumption, where
d(st ) is a measurable function of st . The price of an asset entitling the owner to
this stream must be
1 X
X
0
a0 =
qt0 (st )d(st ):
(7:17)
t=0 st
If this equation did not hold, someone could make unbounded prots by synthesizing this asset through purchases or sales of state-contingent dated commodities
and then either buying or selling the composite asset. We shall elaborate this
arbitrage argument below and in a later chapter on asset pricing.
Riskless consol
As an example, consider the price of a riskless consol, that is, an asset oering
to pay one unit of consumption for sure each period. Then dt(st ) = 1 for all t
and st , and the price of this asset is
1X
X
t=0 st
qt0 (st ):
150
Chapter 7: Competitive Equilibrium with Complete Markets
Riskless strips
As another example, consider a sequence of strips of returns on the riskless
consol. The time- t strip is just the return process d = 1 if = t 0, and
0 otherwise. Thus, the owner of the strip is entitled to just the time- t interest
payment. The value of the time- t strip at time 0 is evidently
X
st
qt0 (st ):
Compare this to the price of the consol reported earlier.
Tail assets
Return to the stream of dividends fd(st)gt0 generated by the asset priced in
equation (7.17). For 1, suppose that we strip o the rst 1 periods of the
dividend and want to get the time-0 value of the dividend stream fd(st)gt .
Specically, we seek this asset value for each possible realization of s . Let
a0 (s ) be the time-0 price of an asset that entitles the owner to dividend stream
fd(st)gt if history s is realized,
a0 (s ) =
X
X
t
fs~t :~s =s g
qt0 (~st )d(~st ):
(7:18)
The units of the price are time-0 (state- s0 ) goods per unit (the numeraire) so
that q00 (s0) = 1. To convert the price into units of time , state s consumption
goods, divide by q0 (s ) to get
a0 (s ) X X qt0 (~st )
d(~s ):
(7:19)
a (s ) 0 =
q (s ) t fs~t :~s =s g q0 (s ) t
Notice that 4
qt0 (st )
q0 (s )
0
= uu0 [[ccit ((ss)])]((ss))
(7:20)
0 [cit (st )]
u
= t u0 [ci (s )] (stjs ):
t
Here qt (s ) is the price of one unit of consumption delivered at time t , state st
in terms of the date- , state- s consumption good; (stjs ) is the probability
qt (st ) t
i
t
t
4 Because the marginal conditions hold for all consumers, this condition holds for all i .
Primer on asset pricing
151
of state st conditional on being in state s at date , as given by (7.3). Thus,
the price at t for the \tail asset" is
a (s ) =
X
t
X
f
s~t :~
s =s
g
qt (~st )d(~st ):
(7:21)
When we want to create a time series of, say, equity prices, we use the \tail
asset" pricing formula. An equity purchased at time entitles the owner to the
dividends from time forward. Our formula (7.21) expresses the asset price in
terms of prices with time , state s good as numeraire.
Notice how formula (7.20) takes the form of a pricing function for a complete
markets economy with date- and state-contingent commodities, whose markets
have been opened at date . Recall Proposition 1 stating that the equilibrium
consumption allocation is not history-dependent, which here implies that the relative price in equation (7.20) is also characterized by a lack of history-dependence
in the following sense:
The equilibrium price of date- t 0, state- st consumption
goods expressed in terms of date j (0 t ), state s consumption goods is
not history-dependent: qt (st ) = qk (~sk ) for j; k 0 such that t = k j and
[st; st 1; : : : ; s ] = [~sk ; s~k 1; : : : ; s~j ].
This property of qt (st ) will play a central role later when we study a recursive
formulation of the model that only allows for sequential trades of one-period
contingent claims.
Proposition 2:
Pricing one period returns
The one-period version of equation (7.20) is
q +1
(
s +1
u0 (ci +1 )
) = u0 (ci ) (s +1js ):
The right side is the one-period pricing kernel at time . If we want to nd the
price at time in state s of a claim to a random payo !(s +1), we use
p (s ) =
X
s +1
q +1 (s +1 )! (s +1 )
152
Chapter 7: Competitive Equilibrium with Complete Markets
or
0
) = E uu(0c(c+1) ) !(s +1) ;
(
(7:22)
where E is the conditional expectation operator. We have deleted the i superscripts on consumption, with the understanding that equation (7.22) is true for
any consumer i ; we have also suppressed the dependence of c on s , which is
implicit.
Let R +1 !(s +1)=p (s ) be the one-period gross return on the asset. Then
for any asset, equation (7.22) implies
u0 (c +1 )
1 = E u0 (c ) R +1 :
(7:23)
The term m +1 u0 (c +1)=u0 (c ) functions as a stochastic discount factor.
Like R +1 , it is a random variable measurable with respect to s +1 , given s .
Equation (7.23) is a restriction on the conditional moments of returns and mt+1 .
Applying the law of iterated expectations to equation (7.23) gives the unconditional moments restriction
u0 (c +1 )
1 = E u0 (c ) R +1 :
(7:24)
In the next section, we display another market structure in which the oneperiod pricing kernel qtt+1 also plays a decisive role. This structure has the
celebrated one-period \Arrow securities," the sequential trading of which substitutes for the comprehensive trading of long horizon claims at time 0 envisioned
previously.
p
s
A recursive formulation: Arrow securities
This section describes an alternative market structure that preserves the equilibrium allocation from our competitive equilibrium. This setting also preserves
the key one-period asset-pricing formula (7.22).
Debt limits
In moving to the sequential formulation, we shall need to impose some restrictions on asset trades to prevent Ponzi schemes. We impose the weakest possible
restrictions in this section. We'll synthesize restrictions that work by starting
A recursive formulation: Arrow securities
153
from the equilibrium allocation of the previous section (with time-0 markets),
and nd some state-by-state debt limits that suÆce to support sequential trading. Often we'll refer to these weakest possible debt limits as the natural debt
limits.
Let qt (s ) be the Arrow-Debreu price, denominated in units of the date t ,
state st consumption good. Consider the value of the tail of agent i 's endowment
sequence at time t in state st :
Ait
( )=
st
1
X
X
=t
fs~ :~st =st g
qt (~s )y i (~s ) Ai (st );
(7:25)
where the denition of the function Ai (st) with st as its sole argument invokes
Proposition 2. Using formula (7.20), evidently Ai (s) solves the recursive equation
u0 [c(s0 )] i 0
Ai (s) = y i (s) + Es 0
A (s );
(7:26)
u [c(s)]
where Es is the expectation conditioned on state s , c(s) is the consumption
of any agent in the Arrow-Debreu complete markets equilibrium with time-0
trading, and 0 denotes a next-period value. (Recall that Proposition 1 states
that the equilibrium consumption allocation is not history-dependent.) We call
Ai (s) the natural debt limit in state s . It is the value of the maximal amount
that agent i can repay starting from state s , assuming that his consumption is
zero forever.
From now on, we shall require that households never promise to pay more
than A(s0 ) in any state s0 tomorrow, because it will not be feasible for them to
repay more.
Arrow securities
We build on an insight of Arrow (1964) that one-period securities are enough
to implement complete markets, provided that new one-period markets are reopened for trading each period. Thus, at each date t 0, trades occur in a
set of claims to one-period-ahead state-contingent consumption. We describe a
competitive equilibrium of this sequential trading economy. With a full array
of these one-period-ahead claims, the sequential trading arrangement attains the
same allocation as the competitive equilibrium that we described earlier.
Before turning to sequential trading, we ask the following question. In the
preceding competitive equilibrium where all trading takes place at time 0, what
154
Chapter 7: Competitive Equilibrium with Complete Markets
is the implied wealth, other than the endowment, of household i at time t in
state st ? In period t , conditional on history st , we sum up the value of the
household's purchased claims to current and future goods net of its outstanding
liabilities. Since history st is realized, all claims and liabilities contingent on
another initial history can be discarded. For example, household i 's net claim
to delivery of goods in a future period t , contingent on history s~ such that
s~t = st , is given by [ci (~s ) y i (~s )]. Thus, the household's wealth, or the value
of all its current and future net claims, expressed in terms of the date t , state st
consumption good is
( )=
i
t
st
1
X
=t
X
f
s~ :~
st =st
g
qt (~s ) ci (~s ) y i (~s )
i (st );
(7:27)
where the denition of the function i (st ) with st as its sole argument invokes
Propositions 1 and 2. Notice that feasibility constraint (7.9) at equality implies
that
I
X
it (st ) = 0; 8t; st:
i=1
In a sequential trading economy, we assume there is a sequence of markets
in one-period-ahead state-contingent claims to wealth or consumption. At each
date t 0, households trade claims to date t + 1 consumption, whose payment
is contingent on the realization of st+1 . Let ti denote the claims to time t
consumption, other than its endowment, that household i brings into time t .
Suppose that Q(s0js) is a pricing kernel to be interpreted as follows: Q(st+1 jst)
gives the price of one unit of time{ t + 1 consumption, contingent on the state at
t +1 being st+1 , given that the state at t is st . Notice that we are guessing that
this function exists and does not depend on t . The household faces a sequence
of budget constraints for t 0, where the time- t budget constraint is
cit +
X
st+1
ti+1 (st+1 )Q(st+1 jst ) y i (st ) + ti :
(7:28)
Here it is understood that ti+1 = ti+1(st+1 ), which depends on the realization
of st+1 and the amount ti+1(st+1 ) purchased at t . At time t , the household
chooses cit and fti+1(st+1 )g, where fti+1 (st+1)g is a vector of claims on time{
t + 1 consumption, one element of the vector for each value of the time{ t + 1
A recursive formulation: Arrow securities
155
state st+1 . To rule out Ponzi schemes, we impose the state-by-state borrowing
constraints
ti+1 (st+1 ) Ai (st+1 );
(7:29)
where Ai are computed in equation (7.26).
Given that the pricing kernel Q(s0js) and the endowment yi(s) are functions
of a Markov process s , we are motivated to seek a recursive solution to the
household's optimization problem. The household i 's state at time t is its wealth
ti and the current realization st . We seek a pair of optimal policy functions
hi (; s), g i (; s; s0) such that the household's optimal decisions are
cit = hi (ti ; st );
ti+1 (st+1 ) = g i (ti ; st ; st+1 ):
(7:30a)
(7:30b)
Let vi (; s) be the optimal value of household i 's problem starting from state
(; s); vi (; s) is the maximum expected discounted utility household i with
current wealth can attain in state s . The Bellman equation for the household's
problem is
(
)
X
v i (; s) = max0 u(c) + v i [~(s0 ); s0 ] (s0js)
(7:31)
~
c;(s
s0
)
where the maximization is subject to the following version of constraint (7.28):
c+
X
s0
~(s0 )Q(s0 js) y i (s) + (7:32)
and also
c 0;
0
~(s ) Ai (s0 ):
(7:33a)
(7:33b)
Let the optimum decision rules be
c = hi (; s);
~(s0 ) = g i (; s; s0):
(7:34a)
(7:34b)
Note that the solution of the Bellman equation implicitly depends on Q(j)
because it appears in the constraint (7.32).
156
Chapter 7: Competitive Equilibrium with Complete Markets
Definition:
0.
A distribution of wealth is a vector ~t = fti gIi=1 satisfying Pi ti =
A recursive competitive equilibrium is an initial distribution of
wealth ~0 , a pricing kernel Q(s0js), sets of value functions fvi (; s)gIi=1 and
decision rules fhi (; s); gi(; s; s0)gIi=1 such that (a) for all i , given 0i and the
pricing kernel, the decision rules solve the household's problem; (b) for all realizations of fst g1
and asset
portfolios ffPcit ; fti+1(s0 )gs0 gi gt
t=0 , the consumptionP
P i
i
implied by the decision rules satisfy i ct = i y (st) and i ti+1 (s0) = 0 for
all t and s0 .
Definition:
Equivalence of allocations
Use the rst-order conditions for the problem on the right of equation (7.31)
and the Benveniste-Scheinkman formula and rearrange to get
Q(st+1 jst ) =
u0 (cit+1 ) (st+1jst )
;
u0 (cit )
(7:35)
where it is understood that cit = hi (ti ; st), ti+1 (st+1 ) = gi(ti ; st; st+1).
By making an appropriate guess about the form of the pricing kernel, it is
easy to show that a competitive equilibrium allocation of the complete markets
model with time-0 trading is also a recursive competitive equilibrium allocation.
Thus, take qt0 (st) as given from the Arrow-Debreu equilibrium and suppose that
the pricing kernel makes the following recursion true:
or
qt0+1 (st+1 ) = Q(st+1 jst )qt0 (st );
Q(st+1 jst ) = qtt+1 (st+1 ):
(7:36)
Let fcit (st)g be a competitive equilibrium allocation. If equation (7.36) is
satised, that allocation is a recursive competitive equilibrium allocation. To
show this fact, take the household's rst-order conditions for the competitive
equilibrium economy from two successive periods and divide one by the other to
get
u0 [cit+1 (st+1 )] (st+1jst ) qt0+1 (st+1 )
= q0 (st ) = Q(st+1 jst):
(7:37)
u0 [ci (st )]
t
t
157
A recursive formulation: Arrow securities
If the pricing kernel satises equation (7.36), this equation is equivalent with the
rst-order condition for the recursive competitive equilibrium economy (7.35).
It remains for us to choose the initial wealth of the recursive equilibrium so
that the recursive competitive equilibrium duplicates the competitive equilibrium
allocation.
We conjecture that the initial wealth vector ~0 of the sequential trading economy should be chosen to be the null vector. This is a natural conjecture, because
it means that each household must rely on its own endowment stream to nance
consumption, in the same way as households are constrained to nance their
state-contingent purchases for the innite future at time 0 in the Arrow-Debreu
economy. To prove that the conjecture is correct, we must show that this particular initial wealth vector enables household i to nance fcit (st)g and leaves no
room for further increasing consumption in any period and state.
The proof proceeds by guessing that, at time t 0 regardless of current state,
household i chooses an asset portfolio given by ti+1 (st+1) = i (st+1 ) for all
st+1 . If the history at date t is st , the value of this asset portfolio expressed in
terms of the date t , state st consumption good is
X
X
ti+1 (st+1 )Q(st+1 jst ) =
i (st+1)qtt+1 (st+1 )
st+1
=
st+1
1
X
=t+1
X
f
s~ :~
st =st
g
qt (~s ) ci (~s ) y i (~s ) ;
(7:38)
where we have invoked expressions (7.27) and (7.36). 5 To demonstrate that
household i can aord this portfolio strategy, we now use budget constraint (7.28)
to compute the implied consumption plan f^ci (s )g. First, in the initial period
t = 0 with 0i = 0, the substitution of equation (7.38) into budget constraint
(7.28) at equality yields
^0 (s0) +
ci
1 X
X
t=1
st
qt0 (st ) cit (st ) y i (st )
= yi(s0 ) + 0:
5 We have also used the following identities,
q 0 (s ) q 0 (st+1 )
qt+1 (s )qtt+1 (st+1 ) = 0 t+1 t+10 t
= qt (s ) for > t:
qt+1 (s ) qt (s )
158
Chapter 7: Competitive Equilibrium with Complete Markets
This expression together with budget constraint (7.5) at equality imply c^i0 (s0) =
ci0 (s0 ). In other words, the proposed asset portfolio is aordable in period 0 and
the associated consumption level is the same as in the competitive equilibrium of
the Arrow-Debreu economy. In all consecutive future periods t > 0 and histories
st , we replace ti in constraint (7.28) by i (st ) and after noticing that the value
of the asset portfolio in (7.38) can be written as
X
st+1
i (st )
ti+1 (st+1 )Q(st+1 jst ) = i
ct
(st) yi (st) ;
(7:39)
it follows immediately from (7.28) that c^it (st) = cit (st) for all periods and histories.
We have shown that the proposed portfolio strategy attains the same consumption plan as in the competitive equilibrium of the Arrow-Debreu economy,
but what precludes household i from further increasing current consumption by
reducing some component of the asset portfolio? The answer lies in the debt limit
restrictions to which the household must adhere. In particular, if the household
wants to ensure that consumption plan fci (s )g can be attained starting next
period in all possible future states, the household should subtract the value of
this commitment to future consumption from the natural debt limit in (7.25).
Thus, the household is facing a self-imposed state-by-state borrowing constraint
that is more restrictive than restriction (7.29): for any st+1 ,
ti+1
or
(st+1 ) Ai (st+1 )
1
X
X
=t+1
fs~ :~st+1 =st+1 g
qt+1 (~s )ci (~s ) =
i (st+1);
ti+1 (st+1 ) i (st+1 ):
Hence, household i does not want to increase consumption at time t by reducing
next period's wealth below i (st+1) because that would jeopardize the attainment of the preferred consumption plan satisfying rst-order conditions (7.35)
for all future periods and states.
We shall use the recursive competitive equilibrium concept extensively in our
discussion of asset pricing in chapter 10.
j -step pricing kernel
159
j -step pricing kernel
We are sometimes interested in the price at time t of a claim to one unit of
consumption at date > t contingent on the time- state being s , regardless
of the particular history by which s is reached at . We let Qj (s0 js) denote
the j -step pricing kernel to be interpreted as follows: Qj (s0js) gives the price
of one unit of consumption j periods ahead, contingent on the state in that
future period being s0 , given that the current state is s . For example, j = 1
corresponds to the one-step pricing kernel Q(s0js).
With markets in all possible j -step ahead contingent claims, the counterpart
to constraint (7.28), the household's budget constraint at time t , is
cit
+
1 X
X
j =1 st+j
i (s
i
i
Qj (st+j jst )zt;j
t+j ) y (st ) + t :
(7:40)
i (s
Here zt;j
t+j ) is household i 's holdings at the end of period t of contingent
claims that pay one unit of the consumption good j periods ahead at date t + j ,
contingent on the state at date t + j being st+j . The household's wealth in the
next period depends on the chosen asset portfolio and the realization of st+1 ,
ti+1
(st+1) =
zt;i 1
(st+1) +
1 X
X
j =2 st+j
Qj
1
i (s
(st+j jst+1 )zt;j
t+j ):
The realization of st+1 determines both which element of the vector of one-period
ahead claims fzt;i 1(st+1 )g that pays o at time t + 1, and the capital gains and
losses inicted on the holdings of longer horizon claims implied by equilibrium
prices Qj (st+j+1jst+1 ).
i (s
With respect to zt;j
t+j ) for j > 1, use the rst-order condition for the problem on the right of (7.31) and the Benveniste-Scheinkman formula and rearrange
to get
X u0 [ci (st+1 )] (st+1 jst )
t+1
Qj (st+j jst ) =
Qj 1 (st+j jst+1 ):
(7:41)
u0 (cit )
st+1
This expression evaluated at the competitive equilibrium consumption allocation,
characterizes two adjacent pricing kernels. 6 Together with rst-order condition
6 According to Proposition 1, the equilibrium consumption allocation is not history dependent,
so that (cit ; fcit+1 (st+1 )gst+1 ) = (ci (st ); fci (st+1 )gst+1 ) . Because marginal conditions hold for
all households, the characterization of pricing kernels in (7.41) holds for any i .
160
Chapter 7: Competitive Equilibrium with Complete Markets
(7.35), formula (7.41) implies that the kernels Qj ; j = 2; 3; : : : can be computed
recursively:
X
Qj (st+j jst ) =
Q1 (st+1 jst )Qj 1 (st+j jst+1 ):
(7:42)
st+1
Arbitrage pricing
It is useful briey to describe how arbitrage pricing theory deduces restrictions on asset prices by manipulating budget sets with redundant assets. 7 We
now present an arbitrage argument as an alternative way of deriving restriction (7.42) that was established above by using households' rst-order conditions
evaluated at the equilibrium consumption allocation. In addition to j -step-ahead
contingent claims, we illustrate the arbitrage pricing theory by augmenting the
trading opportunities in our Arrow securities economy by letting the consumer
also trade an ex-dividend Lucas tree. Because markets are already complete,
these additional assets are redundant. They have to be priced in to leave the
budget set unaltered. 8
Assume that at time t , in addition to purchasing a quantity zt;j (st+j ) of j step-ahead claims paying one unit of consumption at time t + j if the state takes
value st+j at time t + j , the consumer also purchases Nt+1 units of a stock or
Lucas tree. Let the ex-dividend price of the tree at time- t be p(st ). Next period,
the tree pays a dividend d(st+1) depending on the state st+1 . Ownership of the
Nt+1 units of the tree at the beginning of t + 1 entitles the consumer to a claim
on Nt+1 [p(st+1) + d(st+1)] units of time{ t + 1 consumption. 9 As before, let t
be the wealth of the consumer, apart from his endowment, y(st). In this setting,
the augmented version of constraint (7.40), the consumer's budget constraint, is
ct +
and
1 X
X
j =1 st+j
Qj (st+j jst )zt;j (st+j ) + p(st )Nt+1 t + y (st )
t+1 (st+1 ) = zt;1 (st+1 ) + [p(st+1 ) + d(st+1 )] Nt+1
1 X
X
+
Qj 1 (st+j jst+1 )zt;j (st+j ):
(7:43a)
(7:43b)
j =2 st+j
7 Arbitrage pricing theory was advocated by Stephen Ross (1976).
8 That the additional assets are redundant follows from the fact that trading Arrow securities
is suÆcient to complete markets.
9 We calculate the price of this asset using a dierent method in chapter 10.
Consumption strips and the cost of business cycles
161
Multiply
equation (7.43b) by Q1(st+1 jst), sum over st+1 , solve for
P
st+1 Q1 (st+1 jst )z1 (st ), and substitute this expression in (7.43a) to get
8
<
X
ct + p(st )
:
+
st+1
8
1 X<
X
j =2 st+j
X
+
st+1
9
=
Q1 (st+1 jst )[p(st+1 ) + d(st+1 )] Nt+1
;
Qj (st+j jst )
:
X
st+1
Qj
9
=
1
(st+j jst+1)Q1(st+1 jst); zt;j (st+j ) (7:44)
Q1 (st+1 jst )t+1 (s+1 ) t + y (st ):
If the two terms in braces are not zero, the consumer can attain unbounded
consumption and future wealth by purchasing or selling either the stock (if the
rst term in braces is not zero) or a state-contingent claim (if any of the terms
in the second set of braces is not zero). Therefore, so long as the utility function
has no satiation point, in any equilibrium, the terms in the braces must be zero.
Thus we have the arbitrage pricing formulas
p(st ) =
Qj (st+j jst ) =
X
st+1
X
st+1
Q1 (st+1 jst )[p(st+1 ) + d(st+1 )]
Qj
1
(st+j jst+1 )Q1(st+1jst ):
(7:45a)
(7:45b)
These are called arbitrage pricing formulas because if they were violated, there
would exist an arbitrage. An arbitrage is dened as a risk-free transaction that
earns positive prots.
Consumption strips and the cost of business cycles
Consumption strips
This section briey describes ideas of Alvarez and Jermann (1999) and Lustig
(2000). Their purpose is to link measures of the cost of business cycles with
a risk premium for some assets. To this end, consider an endowment economy
with a representative consumer endowed with a consumption process ct = c(st),
where st is Markov with transition probabilities (s0js). Alvarez and Jermann
162
Chapter 7: Competitive Equilibrium with Complete Markets
dene a one-period consumption strip as a claim to the random payo ct , sold
at date t 1. The price in terms of time{ t 1 consumption of this one-period
consumption strip is
at 1 = Et 1 mt ct ;
(7:46)
where mt is the one-period stochastic discount factor
u0 (c )
mt = 0 t :
(7:47)
u (ct 1 )
Using the denition of a conditional covariance, equation (7.46) implies
at 1 = Et 1 mt Et 1 ct + covt 1 (ct ; mt );
(7:48)
where covt 1 (ct ; mt ) < 0. Note that the price of a one-period claim on Et 1 ct
is simply
a~t 1 = Et 1 mt Et 1 ct ;
(7:49)
so that the negative covariance in equation (7.48) is a discount due to risk in the
price of the risky claim on ct relative to the risk-free claim on a payout with the
same mean. Dene the multiplicative risk premium on the consumption strip as
(1 + t 1 ) a~t =at , which evidently equals
1 + t 1 = EtE1mtmEtc 1 ct :
t 1 t t
Link to business cycle costs
(7:50)
The cost of business cycle as dened in chapter 3 does not link immediately
to an asset-pricing calculation because it is intramarginal. Alvarez and Jermann
(1999) and Hansen, Sargent, and Tallarini (1999) were interested in coaxing attitudes about the cost of business cycles from asset prices. Alvarez and Jermann
designed a notion of the marginal costs of business cycles to match asset pricing.
With the timing conventions of Lustig (2000), their concept of marginal cost
corresponds to the risk premium in one-period consumption strips.
Alvarez and Jermann (1999) and Lustig (2000) dene the total costs of business cycles in terms of a stochastic process of adjustments to consumption t 1
constructed to satisfy
E0
1
X
t=0
[(1 + t 1 )ct ] = E0
tu
1
X
t=0
t u(Et 1 ct ):
Gaussian asset pricing model
163
The idea is to compensate the consumer for the one-period-ahead risk in consumption that he faces.
The time- t component of the marginal cost of business cycles is dened as
follows through a variational argument, taking the endowment as a benchmark.
Let 2 (0; 1) be a parameter to index consumption processes. Dene t 1 ()
implicitly by means of
Et 1 uf[1 + t
1
()]ct g = Et 1 u[Et 1ct + (1 )ct ]:
(7:51)
Dierentiate equation (7.51) with respect to and evaluate at = 0 to get
0
0t 1 (0) = Et 1u E(ct )(Ec tu01(cct ) ct 1 ) :
t 1 t
t
Multiply both numerator and denominator of the right side by =u0 (ct 1) to get
0t 1 (0) = Et 1 mEt (Etm1cct ct ) ;
t
t t
1
(7:52)
where we use t 1 (0) = 0. Rearranging gives
1 + 0t 1 (0) = EtE1 mtmEtc 1ct :
t
1
t t
(7:53)
Comparing equation (7.53) with (7.50) shows that the marginal cost of business
cycles equals the multiplicative risk premium on the one-period consumption
strip. Thus, in this economy, the marginal cost of business cycles can be coaxed
from asset market data.
Gaussian asset pricing model
The theory of the preceding section is readily adapted to a setting in which
the state of the economy evolves according to a continuous-state Markov process.
We use such a version in chapter 10. Here we give a taste of how such an
adaptation can be made by describing an economy in which the state follows
a linear stochastic dierence equation driven by a Gaussian disturbance. If we
supplement this with the specication that preferences are quadratic, we get a
setting in which asset prices can be calculated swiftly.
164
Chapter 7: Competitive Equilibrium with Complete Markets
Suppose that the state evolves according to the stochastic dierence equation
st+1 = Ast + Cwt+1
(7:54)
where
A is a matrix whose eigenvalues are bounded from above in modulus by
1=p and wt+1 is a Gaussian martingale dierence sequence adapted to the
history of st . Assume that Ewt+1 wt+1 = I . The conditional density of st+1 is
Gaussian:
(st jst 1 ) N(Ast 1 ; CC 0 ):
(7:55)
More precisely,
(st jst
1
) = K exp :5(st Ast 1)(CC 0 ) 1 (st Ast 1 ) ;
(7:56)
where K = (2) k=2 det(CC 0 ) 1=2 and st is k 1. We also assume that 0 (s0)
is Gaussian. 10
If fcit (st )g1
t=0 is the equilibrium allocation to agent i , and the agent has
preferences represented by (7.4), the equilibrium pricing function satises
qt (
0
st
)=
t u0 [cit (st )]t (st )
:
u0 [ci0 (s0 )]
(7:57)
Once again, let fdt(st )g1
t=0 be a stream of claims to consumption. The time-0
price of the asset with this dividend stream is
a0 =
1Z
X
t
t=0 s
qt0 (st )dt (st )d st :
Substituting equation (7.57) into the preceding equation gives
a0 =
or
XZ
t
u0 [ci (s )]
t 0 it t dt (st )t (st )dst
u [c0 (s0 )]
st
a0 = E
1
X
u0 [c (s )]
t 0 t t dt (st ):
u [c0 (s0 )]
t=0
(7:58)
10 If st is stationary, 0 (s0 ) can be specied to be the stationary distribution of the process.
165
Gaussian asset pricing model
This formula expresses the time-0 asset price as an inner product of a discounted
marginal utility process and a dividend process. 11
This formula becomes especially useful in the case that the one-period utility
function u(c) is quadratic, so that marginal utilities become linear, and that the
dividend process dt is linear in st . In particular, assume that
u(ct ) = :5(ct b)2
(7:59)
dt = Sd st ;
(7:60)
where b > 0 is a bliss level of consumption. Furthermore, assume that the
equilibrium allocation to agent i is
cit = Sci st ;
(7:61)
where Sci is a vector conformable to st .
The utility function (7.59) implies that u0 (cit) = b cit = b Scist . Suppose that
unity is one element of the state space for st , so that we can express b = Sb st .
Then b ct = Sp st , where Sp = Sb Sci , and the asset-pricing formula becomes
a0 =
P
t 0 0
E0 1
t=0 st Sp Sd st
:
Sp s0
(7:62)
Thus, to price the asset, we have to evaluate the expectation of the sum of a
discounted quadratic form in the state variable. This is easy to do by using
results from chapter 1.
In chapter 1, we evaluated the conditional expectation of the geometric sum
of the quadratic form
1
X
0 = E0 t s0t Sp0 Sd st :
t=0
We found that it could be written in the form
0 = s00 s0 + ;
where is an (n n) matrix, and is a scalar that satisfy
= Sp0 Sd + A0 A
= + trace CC 0
(7:63)
(7:64)
11 For two scalar stochastic processes x; y , the inner product is dened as < x; y >= E Pt=0 t xt yt .
1
166
Chapter 7: Competitive Equilibrium with Complete Markets
The rst equation of (7.64) is a discrete Lyapunov equation in the square matrix
, and can be solved by using one of several algorithms. 12 After has been
computed, the second equation can be solved for the scalar .
Concluding remarks
The framework in this chapter serves much of macroeconomics either as foundation or benchmark. It is the foundation of extensive literatures on asset pricing
and risk sharing. We describe the literature on asset pricing in more detail in
chapter 10. The model also serves as benchmark, or point of departure, for a
variety of models designed to confront observations that seem inconsistent with
complete markets, in particular, for models with exogenously imposed incomplete
markets, see chapters 13 on precautionary saving and 14 on incomplete markets;
for models with endogenous incomplete markets, see chapter 15 on enforcement
and information problems; and for models of money, see chapters 17 and 18. To
take only monetary theory as an example, complete markets models dispose of
any need for money because they contain an eÆcient multilateral trading mechanism, with such quick and extensive netting of claims that no medium of exchange
is required to facilitate bilateral exchanges. Any modern model of money introduces a friction that stops complete markets. Some monetary models (e.g., the
cash-in-advance model of Lucas, 1981) impose minimal impediments to complete
markets, to preserve many of the asset-pricing implications of complete markets
models while also allowing classical monetary doctrines like the quantity theory
of money. The shopping-time model of chapter 17 is constructed in a similar
spirit. Other monetary models, such as the Townsend turnpike model of chapter
18 or the Kiyotaki-Wright search model of chapter 19, impose more extensive
frictions on multilateral exchanges and leave the complete markets model farther
behind. But before leaving the complete markets model, we'll put it hard to work
in chapters 8, 9, and 10.
Exercises
Exercise 7.1
Existence of representative consumer
Suppose households 1 and 2 have one-period utility functions u(c1 ) and w(c2), respectively, where u and w are both increasing, strictly concave, twice-dierentiable
12 The Matlab control toolkit has a program called dlyap.m; also see a program called doublej.m.
167
Exercises
functions of a scalar consumption rate. Consider the Pareto problem:
max
u(c1 ) + (1 )w(c2)
1
2
fc ;c g
subject to the constraint c1 + c2 = c . Show that the solution of this problem has
the form of a concave utility function v (c), which depends on the Pareto weight
.
The function v (c) is the utility function of the representative consumer. Such
a representative consumer always lurks within a complete markets competitive
equilibrium even with heterogeneous preferences.
Exercise 7.2
Term structure of interest rates
Consider an economy with a single consumer. There is one good in the economy,
which arrives in the form of an exogenous endowment obeying 13
yt+1 = t+1 yt ;
where yt is the endowment at time t and ft+1 g is governed by a two-state
Markov chain with transition matrix
p
1
p
11
11
P= 1 p
p22 ;
22
and initial distribution = [ 0 1 0 ]. The value of t is given by 1 = :98
in state 1 and 2 = 1:03 in state 2. Assume that the history of ys; s up to
t is observed at time t . The consumer has endowment process fyt g and has
preferences over consumption streams that are ordered by
E0
1
X
t=0
t u(ct )
where 2 (0; 1) and u(c) = c11 , where 1.
a. Dene a competitive equilibrium, being careful to name all of the objects of
which it consists.
13 Such a specication was made by Mehra and Prescott (1985).
168
Chapter 7: Competitive Equilibrium with Complete Markets
Tell how to compute a competitive equilibrium.
For the remainder of this problem, suppose that p11 = :8; p22 = :85; 0 = :5,
= :96, and = 2. Suppose that the economy begins with 0 = :98 and
y0 = 1.
c. Compute the (unconditional) average growth rate of consumption, computed
before having observed 0 .
d. Compute the time-0 prices of three risk-free discount bonds, in particular,
those promising to pay one unit of time- j consumption for j = 0; 1; 2, respectively.
e. Compute the time-0 prices of three bonds, in particular, ones promising to
pay one unit of time- j consumption contingent on j = 1 for j = 0; 1; 2,
respectively.
f. Compute the time-0 prices of three bonds, in particular, ones promising to
pay one unit of time- j consumption contingent on j = 2 for j = 0; 1; 2,
respectively.
g. Compare the prices that you computed in parts d, e, and f.
Exercise 7.3
An economy consists of two innitely lived consumers named
i = 1; 2. There is one nonstorable consumption good. Consumer i consumes cit
at time t . Consumer i ranks consumption streams by
b.
1
X
t=0
t u(cit );
where 2 (0; 1) and u(c) is increasing, strictly concave, and twice continuously dierentiable. Consumer 1 is endowed with a stream of the consumption
good yti = 1; 0; 0; 1; 0; 0; 1; : : :. Consumer 2 is endowed with a stream of the
consumption good 0; 1; 1; 0; 1; 1; 0; : : :. Assume that there are complete markets
with time-0 trading.
a. Dene a competitive equilibrium.
b. Compute a competitive equilibrium.
169
Exercises
Suppose that one of the consumers markets a derivative asset that promises
to pay .05 units of consumption each period. What would the price of that asset
be?
Exercise 7.4 Consider a pure endowment economy with a single representative
consumer; fct ; dtg1
t=0 are the consumption and endowment processes, respectively. Feasible allocations satisfy
ct dt :
The endowment process is described by 14
(1)
dt+1 = t+1 dt :
The growth rate t+1 is described by a two-state Markov process with transition
probabilities
Pij = Prob(t+1 = j jt = i ):
Assume that
:
8
:
2
P = :1 :9 ;
and that
:
97
= 1:03 :
In addition, 0 = :97 and d0 = 1 are both known at date 0. The consumer has
preferences over consumption ordered by
c.
E0
1
X
t=0
t
c1t
1 ;
where E0 is the mathematical expectation operator, conditioned on information
known at time 0, = 2; = :95.
Part I
At time 0, after d0 and 0 are known, there are complete markets in date- and
state-contingent claims. The market prices are denominated in units of time-0
consumption goods.
14 See Mehra and Prescott (1985).
170
Chapter 7: Competitive Equilibrium with Complete Markets
Dene a competitive equilibrium, being careful to specify all the objects
composing an equilibrium.
b. Compute the equilibrium price of a claim to one unit of consumption at date
5, denominated in units of time-0 consumption, contingent on the following
history of growth rates: (1; 2; : : : ; 5) = (:97; :97; 1:03; :97; 1:03). Please give a
numerical answer.
c. Compute the equilibrium price of a claim to one unit of consumption at date 5,
denominated in units of time-0 consumption, contingent on the following history
of growth rates: (1; 2; : : : ; 5 ) = (1:03; 1:03; 1:03; 1:03; :97).
d. Give a formula for the price at time 0 of a claim on the entire endowment
sequence.
e. Give a formula for the price at time 0 of a claim on consumption in period 5,
contingent on the growth rate 5 being :97 (regardless of the intervening growth
rates).
a.
Part II
Now assume a dierent market structure. Assume that at each date t 0 there
is a complete set of one-period forward Arrow securities.
f. Dene a (recursive) competitive equilibrium with Arrow securities, being careful to dene all of the objects that compose such an equilibrium.
g. For the representative consumer in this economy, for each state compute the
\natural debt limits" that constrain state-contingent borrowing.
h. Compute a competitive equilibrium with Arrow securities. In particular,
compute both the pricing kernel and the allocation.
i. An entrepreneur enters this economy and proposes to issue a new security
each period, namely, a risk-free two-period bond. Such a bond issued in period
t promises to pay one unit of consumption at time t + 1 for sure. Find the price
of this new security in period t , contingent on t .
Exercise 7.5
A periodic economy
An economy consists of two consumers, named i = 1; 2. The economy exists
in discrete time for periods t 0. There is one good in the economy, which
171
Exercises
is not storable and arrives in the form of an endowment stream owned by each
consumer. The endowments to consumers i = 1; 2 are
yt1 = st
yt2 = 1
(1)
where st is a random variable governed by a two-state Markov chain with values
st = s1 = 0 or st = s2 = 1. The Markov chain has time-invariant transition
probabilities denoted by (st+1 = s0 jst = s) = (s0js), and the probability
distribution over the initial state is 0 (s). The aggregate endowment at t is
Y (st ) = yt1 + yt2 .
Let ci denote the stochastic process of consumption for agent i . Household i
orders consumption streams according to
(2)
U(
ci
)=
1 X
X
t=0 st
t ln[cit (st )]t (st );
where t (st) is the probability of the history st = (s0; s1; : : : ; st).
t
a. Give a formula for t (s ).
b. Let 2 (0; 1) be a Pareto weight on household 1. Consider the planning
problem
(3)
max
ln(c1 ) + (1 ) ln(c2 )
c1 ;c2
where the maximization is subject to
(4)
c1t (st ) + c2t (st ) Y (st ):
Solve the Pareto problem, taking as a parameter.
b. Dene a competitive equilibrium with history-dependent Arrow-Debreu securities traded once and for all at time 0. Be careful to dene all of the objects
that compose a competitive equilibrium.
c. Compute the competitive equilibrium price system (i.e., nd the prices of all
of the Arrow-Debreu securities).
172
Chapter 7: Competitive Equilibrium with Complete Markets
Tell the relationship between the solutions (indexed by ) of the Pareto
problem and the competitive equilibrium allocation. If you wish, refer to the two
welfare theorems.
e. Briey tell how you can compute the competitive equilibrium price system
before you have gured out the competitive equilibrium allocation.
f. Now dene a recursive competitive equilibrium with trading every period in
one-period Arrow securities only. Describe all of the objects of which such an
equilibrium is composed. (Please denominate the prices of one-period time{ t +1
state-contingent Arrow securities in units of time- t consumption.) Dene the
\natural borrowing limits" for each consumer in each state. Tell how to compute
these natural borrowing limits.
g. Tell how to compute the prices of one-period Arrow securities. How many
prices are there (i.e., how many numbers do you have to compute)? Compute
all of these prices
in the special case that = :95 and (sj jsi ) = Pij where
P = ::83 ::27 .
d.
Within the one-period Arrow securities economy, a new asset is introduced.
One of the households decides to market a one-period-ahead riskless claim to one
unit of consumption (a one-period real bill). Compute the equilibrium prices of
this security when st = 0 and when st = 1. Justify your formula for these prices
in terms of rst principles.
i. Within the one-period Arrow securities equilibrium, a new asset is introduced.
One of the households decides to market a two-period-ahead riskless claim to one
unit consumption (a two-period real bill). Compute the equilibrium prices of this
security when st = 0 and when st = 1.
j. Within the one-period Arrow securities equilibrium, a new asset is introduced.
One of the households decides at time t to market ve-period-ahead claims to
consumption at t + 5 contingent on the value of st+5 . Compute the equilibrium
prices of these securities when st = 0 and st = 1 and st+5 = 0 and st+5 = 1.
h.