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Relationship between risk attitude and economic recovery in optimal growth theory

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  • Herbst, Anthony F.
  • Wu, Joseph S.K.
  • Ho, Chi Pui
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    Abstract

    Policy makers often resort to Keynesian fiscal stimulus to try to stabilize the economy after a major economic downturn. This is nearly always financed with deficit spending and thus debt (under the rubric of quantitative easing11Some note that “quantitative easing” is a modern euphemism formerly called “monetizing the debt.”) which invariably leads to huge budget deficit problems that tend to weaken investor and consumer confidence. Many economists agree it is better to let the economy grow out of the downturn than to finance further deficit spending through increased taxation or by printing money. Economic growth increases employment and generates government revenues to help balance the budget. But policies promoting economic growth often neglect the attitudes of consumers and investors towards risks. Risk-attitude is especially relevant if the shock originates from the financial sector, causing uncertainty and distrust. This paper examines the effect of risk aversion on growth recovery after an economic shock. We find that within the framework of optimal growth theory, risk-attitude determines the strength of the recovery path. We also find that risk-attitude can undermine the effectiveness of low interest rate policies. This highlights the importance of having policies geared towards restoring a stable risk-attitude in the economy. We feel results can best be achieved by resorting more to market mechanisms and less to government intervention. Market transparency and market discipline should be promoted to add certainty and trust so that people can properly form their risk-attitude.

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    Bibliographic Info

    Article provided by Elsevier in its journal Global Finance Journal.

    Volume (Year): 23 (2012)
    Issue (Month): 3 ()
    Pages: 141-150

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    Handle: RePEc:eee:glofin:v:23:y:2012:i:3:p:141-150

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    Web page: http://www.elsevier.com/locate/inca/620162

    Related research

    Keywords: Risk-attitude; Optimal growth theory; Economic recovery;

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    References

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    1. Brock, William A. & Mirman, Leonard J., 1972. "Optimal economic growth and uncertainty: The discounted case," Journal of Economic Theory, Elsevier, vol. 4(3), pages 479-513, June.
    2. Verbrugge, Randal, 2000. "Risk aversion, learning spillovers, and path-dependent economic growth," Economics Letters, Elsevier, vol. 68(2), pages 197-202, August.
    3. Enrico Saltari & Davide Ticchi, 2002. "Risk aversion, intertemporal substitution, and the aggregate investment-uncertainty relationship," Working Papers 69, University of Rome La Sapienza, Department of Public Economics.
    4. Feicht, Robert & Stummer, Wolfgang, 2010. "Complete closed-form solution to a stochastic growth model and corresponding speed of economic recovery," IWQW Discussion Paper Series 05/2010, Friedrich-Alexander-Universität Erlangen-Nürnberg, Institut für Wirtschaftspolitik und Quantitative Wirtschaftsforschung (IWQW).
    5. Shahrokhi, Manuchehr, 2011. "The Global Financial Crises of 2007–2010 and the future of capitalism," Global Finance Journal, Elsevier, vol. 22(3), pages 193-210.
    6. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
    7. Robert Feicht & Wolfgang Stummer, 2010. "Complete Closed-form Solution to a Stochastic Growth Model and Corresponding Speed of Economic Recovery preliminary," DEGIT Conference Papers c015_041, DEGIT, Dynamics, Economic Growth, and International Trade.
    8. Mitra, Tapan & Roy, Santanu, 2010. "Sustained Positive Consumption in a Model of Stochastic Growth: The Role of Risk Aversion," Working Papers 10-03, Cornell University, Center for Analytic Economics.
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