This dissertation analyzes the general equilibrium effects of financial innovation when markets are incomplete. We develop a technique for dealing with one of the fundamental problems confronting general equilibrium analyses of financial innovation--namely that the introduction of a new security essentially represents a structural change in the economy, and thus typically leads to a discrete, non-infinitesimal change in the equilibrium. We term this technique shoehorning because it involves introducing the new asset in such a manner so as to leave the equilibrium virtually unaffected. We use this to demonstrate that when there are several consumption goods in every state of nature, it is almost always possible to find an asset which, when introduced, makes every agent in the economy worse-off, despite the fact that agents have more assets to choose from. Indeed, we show that we can find assets which have any arbitrary effect. We then show that with a single consumption good, despite the fact that an overall welfare loss cannot occur, it is almost always possible to find asset which make all agents better-off. Finally, we assess the implications of the theory of precautionary savings for the effect of financial innovation on the riskless interest rate.
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