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Description:
This paper examines the robustness of the Kiyotaki-Moore collateral amplification mechanism to the existence of complete markets for aggregate risk. We show that, when borrowers can hedge against aggregate shocks at fair prices, the volatility of endogenous variables becomes identical to the first best in the absence of credit constraints. The collateral amplification mechanism disappears. To motivate the limited use of contingent contracts, we introduce costs of issuing contingent debt and calibrate them to match the liquidity and safety premia the data. We .find that realistic costs of state contingent market participation can rationalize the predominant use of uncontingent debt. Amplification is restored in such an environment.