Risk Sharing, Investment, and Incentives in the Neoclassical Growth Model

T he amount of risk sharing among households, regions, or countries is crucial in determining aggregate welfare. For example, pooling resources at the national level can help regions better deal with natural disasters like floods. Similarly, pooling resources with an insurance company can help individuals deal with shocks like a house fire or a car accident. Capital accumulation and economic growth also are crucial in determining aggregate welfare. In particular, they determine the stock of wealth available for consumption and investment. Importantly, wealthier households, regions, or countries possess a buffer stock of precautionary assets, a form of selfinsurance. These two important factors in determining welfare have interesting interactions with one another. An important one is how insurance and savings substitute for each other. For example, individuals may want to save more when they do not have access to insurance than when they do because the extra savings can protect against the consequences of an uninsured shock. Therefore, capital accumulation and growth would be faster in an economy without perfect insurance than in one with perfect insurance. This article explores the tradeoffs between insurance and growth in the neoclassical growth model with two agents and preference shocks. Most of the analysis reviews the full information version of the model, where there are no limits on insurance between the two agents, though there is still aggregate uncertainty that affects aggregate savings behavior. Private information is