RISK, THE FINANCIAL MARKET, AND MACROECONOMIC EQUILIBRIUM

Growing recognition of the importance of stock market phenomena to the real economy underscores the need for models linking exogenous uncertainty, asset market performance, and the rest of the economy in an optimizing framework without certainty equivalence. This paper constructs a three-agent model with continuous-time stochastic variables, uncertain private production and government expenditure, and forward-looking rational agents. The growth rate of output, physical capital accumulation, financial asset returns, and uncertain inflation are determined as functions of the exogenous uncertainty in the economy. Analysis of the model finds that increased risk associated with government policy often reverses in an explainable way the conventional comparative static predictions of nonstochastic macro models.