TAILIEUCHUNG - THE SPIRIT OF CAPITALISM, STOCK MARKET BUBBLES, AND OUTPUT FLUCTUATIONS*

Fund managers will be seeking to understand the dynamics of the business in which the company operates and in particular, potential growth rates into the future. The track record of the company and its senior executives will be of importance. ‘Quality of earnings’ will often govern how much a fund manager will pay for a particular share. A predictable earnings stream and growth trajectory is of great value. Corroboration of profit and loss account by strong and predictable cash-flow is important. The defensibility of a company’s market, in terms of its control over the pricing power of its products or. | The Spirit of Capitalism Stock Market Bubbles and Output Fluctuations Takashi Kamihigashi October 5 2007 Abstract This paper presents a representative agent model in which stock market bubbles cause output fluctuations. Assuming that utility depends directly on wealth we show that stock market bubbles arise if the marginal utility of wealth does not decline to zero as wealth goes to infinity. Bubbles may affect output positively or negative depending on whether the production function exhibits increasing or decreasing returns to scale. In sunspot equilibria the bursting of a bubble is followed by a sharp decline in output one period later. Various numerical examples are given to illustrate the behavior of stochastic bubbles and the relationship between bubbles and output. Keywords Spirit of capitalism stock market bubbles output fluctuations wealth in utility sunspot equilibria JEL Classification E20 E32 This paper is dedicated to late Koji Shimomura. The memory of various discussions with him continues to be a great source of inspiration in many different ways. Earlier versions of the paper were presented at the ISER Osaka University the Workshop of Macroeconomics Osaka and the Department of Economics Hitotsubashi University. Comments from participants are gratefully acknowledged. 1RIEB Kobe University Rokkodai Nada Kobe 657-8501 JAPAN. Email tkamihig@. Tel Fax 81-78-803-7015. 1 Introduction It is popularly believed that the bursting of a stock market bubble is often followed by a severe recession. Famous examples include the Great Depression after the Wall Street Crash of 1929 and Japan s lost decade after the bursting of the Japanese bubble in the early While there is a large empirical literature on the relationship between stock prices and real activ-ity 2 there has been little theoretical research on the effects of stock market bubbles on output fluctuations. The purpose of this paper is to construct a simple general equilibrium model

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