Uninsured idiosyncratic investment risk and aggregate saving

the long version

This paper augments the neoclassical growth model to study the macroeconomic effects of idiosyncratic investment risk. The general equilibrium is solved in closed form under standard assumptions for preferences and technologies. A simple condition is identified for incomplete markets to result in both a lower interest rate and a lower capital stock in the steady state: the elasticity of intertemporal substitution must be higher than the income share of capital. For plausible calibrations of the model, the reduction in the steady-state levels of aggregate savings and income relative to complete markets is quantitatively significant. Finally, cyclical variation in private investment risks is shown to amplify the transitional dynamics. Keywords: incomplete markets, heterogeneity, private equity, entrepreneurial risk, precautionary savings, amplification. JEL Classifications: D52, E13, E32, G11, O16, O41