The Value of Uncertainty under Limited Commitment

In this paper, I analyze a simple financial contracting problem between a riskneutral financial intermediary and a risk-averse household, where the household receives an endowment that grows over time, and is unable to commit to the contract. I argue that in this environment, the presence of uncertainty in the household’s endowment may improve the household’s welfare by relaxing its commitment problem and thus enabling the contract to achieve more efficient allocations. I analytically and numerically examine the conditions under which this is true, and show that it requires sufficiently rapid growth of endowment. This result suggests that a slowdown in growth may have a disproportionately large effect on welfare, which has potentially important practical implications, for example, for developing countries. ∗I thank seminar participants at the 2008 GRIPS Conference on Growth and Development, University of Hitotsubashi, GRIPS and the Fifth Joint Conference of the University of Tokyo and Seoul National University. All remaining errors are mine. Comments welcome. E-mail: [email protected]