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Recursive macroeconomic theory, Thomas Sargent 2nd Ed - Chapter 19

Chapter 19 Insurance Versus Incentives 19.1. Insurance with recursive contracts This chapter studies a planner who designs an efficient contract to supply insurance in the presence of incentive constraints imposed by his limited ability either to enforce contracts or to observe households’ actions or incomes. | Chapter 19 Insurance Versus Incentives 19.1. Insurance with recursive contracts This chapter studies a planner who designs an efficient contract to supply insurance in the presence of incentive constraints imposed by his limited ability either to enforce contracts or to observe households actions or incomes. We pursue two themes one substantive the other technical. The substantive theme is a tension that exists between providing insurance and instilling incentives. A planner can overcome incentive problems by offering carrots and sticks that adjust an agent s future consumption and thereby provide less insurance. Balancing incentives against insurance shapes the evolution of distributions of wealth and consumption. The technical theme is how incentive problems can be managed with contracts that retain memory and make promises and how memory can be encoded recursively. Contracts issue rewards that depend on the history either of publicly observable outcomes or of an agent s announcements about his privately observed outcomes. Histories are large-dimensional objects. But Spear and Srivastava 1987 Thomas and Worrall 1988 Abreu Pearce and Stacchetti 1990 and Phelan and Townsend 1991 discovered that the dimension can be contained by using an accounting system cast solely in terms of a promised value a one-dimensional object that summarizes relevant aspects of an agent s history. Working with promised values permits us to formulate the contract design problem recursively. Three basic models are set within a single physical environment but assume different structures of information enforcement and storage possibilities. The first adapts a model of Thomas and Worrall 1988 and Kocherlakota 1996b that focuses on commitment or enforcement problems and has all information being public. The second is a model of Thomas and Worrall 1990 that has an incentive problem coming from private information but that assumes away commitment and enforcement problems. Common to both of these