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World Finance and the Us 'New Economy': Risk Sharing and Risk Exposure

36 Pages Posted: 11 May 2005  

Marcus H. Miller

University of Warwick - Department of Economics; Institute for International Economics; Centre for Economic Policy Research (CEPR)

Lei Zhang

University of Warwick - Department of Economics

Date Written: January 2005

Abstract

The promising prospect of a 'New Economy' in the US attracted substantial equity inflows in the late 1990s, helping to finance the country's burgeoning current account deficit. After peaking in 2000, however, US stocks fell by some 8 trillion dollars in value. To assess the welfare effects of international financial markets in this context, we use an analytically tractable (two-country, two-period, two-state) model of the global economy which allows the country experiencing the favorable supply side 'shock' to consume more against expected future output and to spread risk by selling shares. Since irrational exuberance and distorted corporate incentives can cause serious asset overvaluation, however, an asset price 'bubble' is also included, where market participants assign unwarranted likelihood to high pay offs. Relative to autarky, internationalizing financial markets does offer welfare gains. But these are small relative to the international wealth transfer that can arise from selling shares globally at inflated prices. Parameter variations suggest that this conclusion is quite robust. A calibrated exercise shows how capital inflows to finance the 'New Economy' can be twice the consumption-smoothing deficit on current account; and how market losses - due to 'misfortune' or 'excess upside probability' - can have global effects on consumption when the bubble bursts. The analysis complements recent econometric studies of the transmission mechanism which find that financial factors are needed to explain why the European economy was so strongly affected by the US downturn starting in 2002.

Keywords: Capital flows, moral hazard, international transmission of shocks

JEL Classification: F32, F41, G15

Suggested Citation

Miller, Marcus H. and Zhang, Lei, World Finance and the Us 'New Economy': Risk Sharing and Risk Exposure (January 2005). CEPR Discussion Paper No. 4855. Available at SSRN: https://ssrn.com/abstract=721592

Marcus Miller (Contact Author)

University of Warwick - Department of Economics ( email )

Coventry CV4 7AL
United Kingdom
+44 24 7652 3048/9 (Phone)
+44 24 7652 3032 (Fax)

Institute for International Economics

1750 Massachusetts Avenue, NW
Washington, DC 20036-1903
United States

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Lei Zhang

University of Warwick - Department of Economics ( email )

Coventry CV4 7AL
United Kingdom
+44 24 7652 2983 (Phone)
+44 24 7652 3032 (Fax)

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