Asset prices in a Huggett economy

This paper explores the asset-price implications in economies where there is no direct insurance against idiosyncratic risks but where there are other assets— such as a riskfree bond or equity—that can be used for self-insurance, subject to exogenously imposed borrowing limits. We analyze an economy without production—an endowment economy—and we consider both the case with no aggregate risk and the case with aggregate risk. Thus, we analyze the economy originally studied, in the case without aggregate risk, in Huggett (1993). Our main innovation is that, by studying the case with “maximally tight” borrowing constraints, we can obtain full analytical tractability. Thus, like in Lucas’s (1978) seminal asset-pricing paper, we obtain closed forms for all state-contingent claims, allowing us to study the price determination for all assets with payoffs contingent on aggregate events. In the Huggett economy that we analyze, like in Lucas’s, any asset pricing is obtained using a first-order condition, but in the Huggett economy only a subset of the consumers will typically have firstorder constraints holding with equality—the others are borrowing-constrained. Thus, the analysis centers around who prices the assets, and around what the endowment risks of this agent are; in the Lucas economy, only the aggregate endowment risk matters. Moreover, identity/type of the consumer pricing an asset may change over time. We specifically illustrate by looking at riskless bonds, equity, and the term structure of interest rates, and we show that the model with tight constraints can reproduce observed features of asset prices when idiosyncratic risks are quantitatively reasonable. The authors acknowledge helpful comments from participants at the 2008 Midwest Macro Meetings, at the Murray S. Johnson Memorial Conference in honor of Truman F. Bewley, held at the University of Texas at Austin in April 2009, at the “Recent Developments in Macroeconomics” conference at Yonsei University, as well as from the editor and two anonymous referees. Krusell is at the Institute for International Economic Studies, CAERP, CEPR, and NBER; Mukoyama is at the University of Virginia and CIREQ; Smith is at Yale University.