Risk sharing in the business cycle

Abstract

Why do all developed economies experience fluctuations in their economic activity? The real business cycle (RBC) literature has provided an answer to this question by demonstrating that a well functioning decentralized model economy subject to exogeneous productivity shocks will behave in a way similar, in many respects, to the business fluctuations experienced by actual economies [Kyland and Prescott (1982)]. This is particularly true if one imposes restrictions on the choice set of the representative consumer-worker [Hansen (1985)]. Taking account of demand shocks in the form of variations in government spending further improves the performance of the model [Christian0 and Eichenbaum (1990)]. Should we be content with this answer? First, we must observe that the set of facts current RBC models are able to replicate is very limited and thus that claims of theoretical success should be proportionately modest [Danthine and Donaldson (1990)]. Second, at this level of explanation, it is quite likely that the same modest set of facts currently used to define the business cycle will be consistent with models of the economy which are significantly different from the pure Walrasian formulations which have predominated to date. It is this latter issue tihich we propose to address in this paper. Our starting point is the observation that all industrial economies have developed institutional and social arrangements designed to improve the distribution of income and risks over what would prevail in Walrasian equilibrium. Trade unions, minimum wage laws, and unemployment compensation mechanisms are examples of such arrangements, and they could be all interpreted as having the objective either of moving the economy away from