The Welfare Consequences of Irrational Exuberance: Stock Market Booms, Research Investment, and Productivity

29 Pages Posted: 30 Aug 2007

See all articles by Michal Jerzmanowski

Michal Jerzmanowski

Clemson University - John E. Walker Department of Economics

Malhar Nabar

Wellesley College

Abstract

This paper studies the effects of stock market valuation on research investment, the rate of innovation and welfare. In the presence of financing constraints for R&D investment, episodes of high market valuation can ease these constraints and raise the economy-wide investment in R&D and the rate of innovation. If the decentralized equilibrium rate of innovation is inefficiently low, then such episodes may lead to an increase in aggregate welfare even if the higher valuation is not entirely justified by fundamentals. We present a Schumpeterian-style growth model with a costly financial intermediation process to characterize the relationship between market value, entry of new firms, and the aggregate rate of innovation. We use the model to measure welfare consequences of a stock market run-up that may only partly be justified by fundamentals. In particular we apply the model to the US economy in the 1990s and calibrate the impact of the NASDAQ boom on the rate of innovation, output growth and welfare. The welfare effect depends on the underlying change in fundamentals. We find that with an acceleration in US trend productivity growth from a pre-1995 rate of 1.4% to a rate of 2.0 % per annum, the NASDAQ boom will have resulted in a net welfare gain of 0.55%. If the new growth rate is as high as 3%, the net gain was 1.35% of the present discounted value of consumption.

Keywords: Stock market bubbles, Financing constraints, Innovation, Welfare

JEL Classification: G12, G14, O31, O16, O40

Suggested Citation

Jerzmanowski, Michal and Nabar, Malhar, The Welfare Consequences of Irrational Exuberance: Stock Market Booms, Research Investment, and Productivity. Journal of Macroeconomics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1010657

Michal Jerzmanowski (Contact Author)

Clemson University - John E. Walker Department of Economics ( email )

Clemson, SC 29634
United States

Malhar Nabar

Wellesley College ( email )

106 Central St.
Wellesley, MA 02181
United States

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