Computing Equilibria in Finance Economies with Incomplete Markets and Transaction Costs

Transaction costs in financial markets may have important consequences for volumes of trade, asset pricing and welfare. In the economic literature they are often given as one reason for the incompleteness of asset markets, which is a striking example of their potential impact on volumes of trade. We argue that analytical results on the impact of transaction costs are hard to obtain and a computational approach is needed. This paper introduces the first algorithm for the computation of equilibria in the general equilibrium model with incomplete asset markets and linear transaction costs on the financial markets. The algorithm is based on the homotopy principle and is able to deal with the two major technical difficulties of the model, namely the existence of non-differentiabilities of agents'' asset demands as a function of the asset prices and the existence of locally non-unique equilibria. Several numerical examples give a first glimpse of the impact of transaction costs on the nature of the equilibria. We show that the consequences of transaction costs for volumes of trade and prices can be counterintuitive even for small economic models.