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The welfare consequences of irrational exuberance: Stock market booms, research investment, and productivity

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  • Jerzmanowski, Michal
  • Nabar, Malhar

Abstract

This paper studies the effects of stock market valuation on research investment, the rate of innovation, and welfare. In the presence of financing constraints for R&D investment, episodes of high market valuation can ease these constraints and raise the economy-wide investment in R&D and the rate of innovation. If the decentralized equilibrium rate of innovation is inefficiently low, then such episodes may lead to an increase in aggregate welfare even if the higher valuation is not entirely justified by fundamentals. We present a Schumpeterian-style growth model with a costly financial intermediation process to characterize the relationship between market value, entry of new firms, and the aggregate rate of innovation. We use the model to measure the welfare consequences of a stock market run-up that may only partly be justified by fundamentals. In particular, we apply the model to the US economy in the 1990s and calibrate the impact of the NASDAQ boom on the rate of innovation, growth and welfare. The welfare effect depends on the underlying change in fundamentals. We find that with an acceleration in US trend productivity growth from a pre-1995 rate of 1.4% to a rate of 2.0% per annum, the NASDAQ boom will have resulted in a net welfare gain of 0.55%. If the new growth rate is as high as 3%, the net gain was 1.35% of the present discounted value of consumption.

Suggested Citation

  • Jerzmanowski, Michal & Nabar, Malhar, 2008. "The welfare consequences of irrational exuberance: Stock market booms, research investment, and productivity," Journal of Macroeconomics, Elsevier, vol. 30(1), pages 111-133, March.
  • Handle: RePEc:eee:jmacro:v:30:y:2008:i:1:p:111-133
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    References listed on IDEAS

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    Cited by:

    1. Berg, Nathan & Kim, Jeong-Yoo, 2010. "Demand for Self Control: A model of Consumer Response to Programs and Products that Moderate Consumption," MPRA Paper 26593, University Library of Munich, Germany.
    2. Aramonte, Sirio, 2015. "Innovation, investor sentiment, and firm-level experimentation," Finance and Economics Discussion Series 2015-67, Board of Governors of the Federal Reserve System (U.S.).
    3. Malhar Nabar & Michal Jerzmanowski, 2007. "Financial Development and Wage Inequality: Theory and Evidence from US States," 2007 Meeting Papers 890, Society for Economic Dynamics.
    4. Narayan, Paresh Kumar & Sharma, Susan Sunila & Phan, Dinh Hoang Bach, 2016. "Asset price bubbles and economic welfare," International Review of Financial Analysis, Elsevier, vol. 44(C), pages 139-148.

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