Transfer programs under alternative insurance schemes and liquidity constraints

Abstract

We consider a dynamic allocation problem under alternative insurance and capital market regimes and proper risk aversion separate from intertemporal substitution. We apply the model to study the effect of one-size-fits-all transfers. We find that one-size-fits-all transfers can have different and diametrically opposed qualitative and quantitative effects on consumption, investment, expected growth of output and consumption and the fair price of insurance of the risky technology. The differences depend upon the regime of insurance to the risky technology, the regime of capital markets and the proper separate measures of risk aversion and intertemporal substitution.

Keywords:

• transfers
• insurance
• liquidity constraint
• intertemporal substitution
• risk aversion

JEL Classifications:

• F4
• F34
• D9

Acknowledgements

The author is grateful for the comments and discussions with Yannis Ioannides on material relating to this research; and the useful comments and suggestions of anonymous referees. Any errors are the author's own.

Notes

1. See the recent studies of Boldrin and Canova (2001) and Puga (2000) for descriptions of these policies and programs; and the recent evaluation in the Sapir (2003) report, and Economides, Kalyvitis and Philippopoulos (2004). In terms of fiscal policies and transfers see also Checherita, Nickel and Rother (2009).

2. Relative to the EU, the US has a much smaller disparity in per capita income levels. For example, Boldrin and Canova (2001) report that the ratio between the income per capita of the richest and poorest states in the US is less than 2 while in the EU it is more than 5. In another important dimension, the US presents much higher mobility of labor than the EU. The emphasis of this paper is on a transfer of initial endowment in income. Yet, other income support programs to specific sectors such as farmers and labor have existed throughout the EU. In the case of the EU, one of the main areas of focus has been public infrastructure. Transfers are setup for specific public investments in certain regions of countries identified as having income per capita well below the average of the EU. One of the key aspects of the programs is that a recipient nation must co-finance the specific infrastructure project both with public and private sector funds. Economists understand this ‘additionality’ principle as a simple mechanism, designed to provide incentives for the best use of the resources in the economy. The EU is using such mechanisms to even screen potential new members from Eastern Europe in a new 2001–2006 program. The main recipient nations from the 1990s programs have been Greece, Ireland, Portugal and Spain. The recipients of the new wave of transfers include Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia; see, for example, Chatterjee, Sakoulis and Turnovsky (2003). There are of course political reasons behind the transfer schemes as well. For example, the 1990s' program may be perceived as a premium for the poorest regions for the admission of Austria, Finland and Sweden in the union.

3. From a pure policy perspective, one-size-fits-all transfers also have the goal of reducing income inequality, see e.g. Keane and Prasad (2002), Checherita, Nickel and Rother (2009). This angle is not pursued in this paper, instead it focuses on the consumption, investment, expected growth of output and consumption and the fair price of insurance of the risky technology effects.

4. Obstfeld (1994) present a recent application of this class of preferences in closed economies, and Giuliano and Turnovsky (2003) present an application in small open economies. Kimball and Weil (2003) present an analysis of precautionary saving under this class of preferences in a two-period model. See also Bianconi (2003) for a survey of models in discrete and continuous time; and more recently Skiadas (2009).

5. Another important literature builds on the seminal contributions of Persson and Tabellini (1996a,b). They follow a political-economy approach focusing on voting schemes associated with the transfers.

6. The coefficients are a ₁₁≡U ₁₁-U ₁₃; a ₁₂≡U ₁₃ – U ₃₃ – U ₁₂ + U ₂₃; a ₂₁≡U ₁₁ – 2RU ₁₂ + RU ₁₂ + R ² U ₂₂; a ₂₂≡U ₁₃ – RU ₂₃ – RU ₁₂ + R ² U ₂₂; b ₁≡U ₂₃ – U ₁₂; b ₂≡R(RU ₂₂–U ₁₂); and U ₁₁(c ₁, c ₂, k) = ∂² U/∂c ₁ ², etc.