Governmental Risk Taking Under Market Imperfections: Working Paper 2021-07
Working Paper
This paper explores the benefits and costs of governmental risk taking in formal models of market imperfections, in which the government serves as an intermediary between different stakeholders in its finances.
An extensive literature debates whether market prices should be used to measure the benefits and costs of risk in government activities or whether the government should be treated as risk neutral. This paper explores the benefits and costs of governmental risk taking in formal models of market imperfections, in which the government serves as an intermediary between different stakeholders in its finances. Some stakeholders cannot participate in markets, either because they belong to future generations or because they have no funds to invest and face borrowing constraints. The cost of risk for those government stakeholders might not be equal to market price under laissez-faire but will be the same as market prices under Pareto-efficient policy, which creates inframarginal benefits. In an overlapping generations model, the market price of risk might understate or overstate the cost of risk that is shifted by the government to future generations, depending on whether uncertainty is driven by permanent or temporary shocks to technology. Permanent shocks to technology lead the market price of risk to understate the cost of risk to future generations, whereas temporary shocks cause it to overstate the cost of such risk.
