Financial Markets and Stochastic Growth

Abstract

The authors study the effect of financial markets on the investment of a two‐good two‐country economy with stochastic production in a dynamic framework. Each country produces and invests only one good and, therefore, makes decisions as a central planner in an optimal growth model. Trade between consumers of both countries, however, takes place on competitive (spot or financial) markets. The authors compare the investment–consumption decisions of both “market” models with the benchmark case of an integrated world‐equilibrium. In the log‐linear case, it is possible to uniquely characterize the state‐dependent preferences of consumers that lead to dynamically efficient investment decisions. It is shown that the investment decisions in both “market” models are, in general, inefficient compared with the efficient, or integrated world economy, case.