Incomplete markets and volatility

This paper shows that the precautionary motive, combined with asset incompl eteness, is a major source of volatility and indeterminacy in financial mar kets. Price fluctuations originate from agents' efforts to insure themselve s through time by borrowing and lending instead of shifting income across s tates or nature by trading risky assets. A high interest rate at a future d ate reduces the potential for future consumption smoothing via borrowing. w hich leads to a strong precautionary motive and a low interest rate in the current period. The negative feedback between future and current rates gene rates fluctuations. This logic is developed in SPEC. a CARA-normal exchange economy with many periods and endogenous interest rates. When there is an intermediate level of market incompleteness and sufficient investor impatie nce. fluctuations in the real interest rate can be large. even though the a ggregate endowment is constant. SPEC has a unique equilibrium under a finit e horizon. on the other hand. with a finite number of infinitely lived agen ts. there exists a robust continuum of equilibria that are neither bubbles nor sunspots. (C) 2001 Academic Press.