Incomplete Markets, Labor Supply and Capital Accumulation

Abstract

We explore the accumulation of capital in the presence of limited insurance against idiosyncratic shocks, borrowing constraints and endogenous labor supply. In the exogenous labor supply case (e.g. Aiyagari 1994, Huggett 1997), the presence of limited insurance increases the demand for savings for precautionary reasons. As a consequence, capital and output are higher under incomplete markets. We show that if labor hours are endogenous, labor supply is likely to be lower under incomplete markets, because those agents who experience a high shock to productivity are ex post richer and they work fewer hours. In some cases, this wealth effect can overcome the "aggregate precautionary savings" and give rise to lower savings and output under incomplete markets.