Incomplete Markets and Volatility.

This paper shows that the precautionary motive, combined with asset incompleteness, is a major source of volatility and indeterminacy in financial markets. Price fluctuations originate from agents' efforts to insure themselves through time by borrowing and lending instead of shifting income across states of nature by trading in risky assets. A high interest rate at a future date reduces the potential for future consumption smoothing across time via borrowing, leading to a strong precautionary motive and a low interest rate in the current period. The negative feedback between future and current interest rates generates fluctuations.