General economic equilibrium with financial markets and retainability

Abstract

A theory of economic equilibrium for incomplete financial markets in general real assets is developed in a new formulation with currency-denominated prices. The "goods" are not only commodities, and they can influence utility through retention as an alternative to consumption. Perfect foresight is relinquished in a rolling horizon approach to markets which lets agents pursue long-term interests without being sure of future prices. The framework is that of an economy operating in a fiat currency that agents find attractive to retain, in balance with other needs. The attractiveness comes from Keynesian considerations about uncertainty which until now have not been brought in. The existence of equilibrium is established directly-not just generically-and moreover under weaker assumptions on endowments than before, except that utility functions are taken to be concave. Agents do not need to start out with, or end up with, positive amounts of everything. With a single currency denominating the units of account in all states, price indeterminacy is avoided and all contracts issued in the financial markets can be interpreted as "real contracts." Derivative instruments and collateralized contracts based on money prices are thereby encompassed for the first time. Transaction costs on sales of contracts, generated endogenously, lead to bid-ask spreads and in particular to a gap between interest rates for lending and borrowing money.