Imperfect Risk Sharing, Output-Ination Tradeo¤s and Business Cycles

How do frictions in asset markets a¤ect business cycle dynamics? This paper argues that imperfect risk-sharing among heterogeneous households, due to frictions in asset markets, ampli…es price stickiness endogenously and consequently increases the persistence and volatility of business cycles. The main economic mechanism is an idiosyncratic wealth e¤ect on individual household’s labor supply. This result provides a way to understand two con‡icting observations based on macro and micro data: (1) The model is able to generate persistent aggregate dynamics, being consistent with micro evidence of frequent price adjustments. (2) The model is consistent with large elasticity of aggregate labor supply as well as small elasticity of individual labor supply. I am greatly indebted to Chris Sims for his valuable advice. I also thank Nobuhiro Kiyotaki, Ricardo Reis, Sam Schulhofer-Wohl, Lars Svensson, Per Krusell, Roberto Chang, Tack Yun, Jinil Kim, Jonathan Heathcote, Carlos Carvalho, Jae Sim, Woong Yong Park, and participants of seminars at Princeton, Rutgers, Ohio State, Indiana, UC-Davis, Georgetown, FRB-Boston and the Federal Reserve Board for helpful comments and discussions. A part of this project was completed while I was visiting the FRB. I wish to thank the International Finance Division of the FRB for its hospitality.