An Introduction to General Equilibrium with Incomplete Asset Markets*

The theory of general equilibrium with incomplete asset markets (GEI) studies the pricing of securities and commodities, and the interactions of perfectly competitive asset markets and commodity markets in determining consumption and investment. Since financial economics is fundamentally concerned with the pricing of securities, and since macroeconomics is fundamentally concerned with the real effects of monetary assets, the GE1 model provides a framework for a microeconomic analysis that touches a variety of fields. The theory of general equilibrium with incomplete asset markets is much more general than the Arrow-Debreu model, but it maintains the same methodological approach: agents optimize, their expectations are rational (that is, they have perfect conditional foresight, though they do not know the state of nature in advance), markets clear, and all market transactions are anonymously arranged under conditions of perfect competition. Yet, as we shall see, many of the lessons of the Arrow-Debreu model are apparently reversed. Many new phenomena that cannot be described in the Arrow-Debreu model come to light in the incomplete asset markets model. These include the distinction between real and financial assets, the limitations (for understanding local uniqueness and efficiency) of representative agent and single commodity models, the non-neutrality (and occasional neutrality) of money, the importance of diversification, the dependence of asset prices on covar-