Risk Aversion, Unemployment, and Aggregate Risk Sharing with Financial Frictions

Abstract

If agents in workhorse business cycle models with financial frictions are allowed to index contracts to observable aggregates, they share aggregate financial risk (almost) perfectly. Thus, the borrowing-constrained capital holders' wealth share does not collapse following adverse shocks and the financial accelerator mechanism is eliminated. I revisit this issue in the Bernanke, Gertler, and Gilchrist (1999), henceforth BGG, framework and show that this happens in the standard specification with TFP shocks partly because: i) borrowers and lenders are implicitly assumed to have identical, logarithmic utility, and ii) the representative lender's human wealth comoves closely with aggregate financial wealth. I then demonstrate that non-state-contingent borrowing rates, as initially imposed by BGG, can arise optimally in light of TFP shocks if: i) lenders' aversion to consumption fluctuations is increased to plausible degrees, or ii) at identical preferences for consumption, lenders face uninsurable idiosyncratic liquidity risk brought about by loss of employment.