The Failure of The Standard Complete Markets Model
Many authors have argued that modeling incomplete markets and other sorts of financial frictions is crucial to explain the counterfactual predictions of the standard Complete Market models. The most notable example is the equity premium puzzle Mehra and Prescott (1985), where the Complete Market model failed to explain the historical high equity premium and low risk-free rate.
Along with the Equity premium puzzle other counterfactual implications of the Complete Market model are related to the empirical observations concerning individuals’ consumption, wealth and market transactions. For example, in a Complete Market framework, given that agents can fully insure against idiosyncratic risks, each individual’s consumption must fluctuate as much as anyone else’s, and the relative position in terms wealth distribution of an individual should not vary much over time. The empirical evidence suggests otherwise. Further, the individual consumptions are not highly correlated which each other and wealth holdings are very volatile.
Read more about this topic: Incomplete Markets
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