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

Marcus Miller () and Lei Zhang
Authors registered in the RePEc Author Service: Lei Zhang () and Lei Zhang ()

No 4855, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 favourable 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; international transmission of shocks; moral hazard (search for similar items in EconPapers)
JEL-codes: F32 F41 G15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin and nep-fmk
Date: 2005-01
View list of references

Downloads: (external link)
http://www.cepr.org/pubs/dps/DP4855.asp (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:cpr:ceprdp:4855

Ordering information: This working paper can be ordered from
http://www.cepr.org/pubs/dps/DP4855.asp

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers
Address: Centre for Economic Policy Research, 53--56 Great Sutton Street, London EC1V 0DG
Series data maintained by ().