MICRO/THEORY: Rich by accident: the second welfare theorem with a redundant asset under imperfect foresight; Professor Atsushi Kajii (Kwansei Gakuin University)

Abstract:

In a T-period model with perfect foresight and no uncertainty, markets are complete with short-term bonds. The no-arbitrage principle renders any additional asset redundant, with no implications for allocation. Relaxing the perfect foresight assumption, we consider a reasonable version of temporary equilibria that accommodates sensible forecasts while maintaining no-arbitrage. With only short-term bonds, even allowing for forecasting errors, only a T-dimensional subset of efficient allocations can arise as Walrasian equilibria. However, if long-term bonds are traded in addition, essentially all efficient allocations can be achieved as equilibria, whereas forecasting errors may be arbitrarily small. We argue that minute errors in price forecasts can generate any feasible wealth transfer within the model, and that the beneficiaries of such transfers are determined by chance, not by superior forecasting ability.

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