Human Capital Risk and Economic Growth

Abstract

This paper develops a tractable incomplete-markets model of economic growth in which households invest in risk-free physical capital and risky human capital. The paper shows that a reduction in uninsurable idiosyncratic labor income risk decreases physical capital investment, but increases human capital investment, growth, and welfare. A quantitative analysis based on a calibrated version of the model reveals that these effects are substantial and of the same order of magnitude as the effects of distortionary income taxation. The analysis further suggests that government-sponsored severance payments to displaced workers increase growth and welfare even if these payments have to be financed through distortionary income taxation. * This paper previously circulated under the title "Idiosyncratic Risk, Aggregate Saving, and Economic Growth." I would like to thank the editor (Alberto Alesina) and an anonymous referee for many insightful comments. Section IV and Appendix 2 are based on their suggestions. I also wish to thank for helpful comments Oded Galor,

Recursive equilibrium in endogenous growth models with incomplete markets

“…Because of space limitations, this paper did not discuss any applications of the framework to macroeconomic policy analysis. However, the model has already been used to study the growth and welfare effects of social insurance (Krebs 2001) and the welfare cost of business cycles (Krebs, 2002a).…”

“…Consequently, the two models may lead to very different policy conclusions. For example, whereas social insurance of idiosyncratic risk has no effect on growth and welfare in the complete-markets economy, it has a substantial effect in the incomplete-markets economy (Krebs, 2001). Moreover, the welfare cost of business cycles are likely to be much larger when markets for idiosyncratic risk are incomplete (Krebs, 2002a).…”

“…Finally, there is the work by Scheinkman and Weiss (1986) and Woodford (1986) who consider models with two infinitely-lived agents that are isomorphic to two-period OLG-models because individual endowments fluctuate deterministically. In contrast to this work, the current model allows for a wide range of distributions of idiosyncratic shocks, a feature that is essential when calibrating the model based on household-level consumption and income data (Krebs 2001(Krebs , 2002a we interpret s it as a household-specific (idiosyncratic) shock and S t as an economy-wide (aggregate) shock. We assume that s it is an element of a time-and household-independent set s, and that S t is an element of a time-invariant set S. To avoid mathematical technicalities, the formal proofs also assume that the two sets s and S are finite.…”

Learning for a bonus: How financial incentives interact with preferences

“…Just as investors in financial capital, investors in human capital are also concerned about the certainty and risk of the returns of an investment (Brunello, 2002;Krebs, 2003;Levhari and Weiss, 1974). Students who are relatively more risk averse choose to invest less in education when the benefits thereof are uncertain.…”

Secular Stagnation? Growth, Asset Returns and Welfare in the Next Decades: First Results

“…We avoid such restrictions by employing a large scale overlapping generations model that runs at an annual frequency. To significantly reduce computational costs we adopt the risky human capital framework developed in Krebs (2003) and Krebs and Wilson (2004). This setup gives rise to closed form solutions of households' policy functions for consumption and total saving, conditional on the law of motion of the aggregate state of the economy and the solution for optimal portfolio shares.…”