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The Stock Market in the Overlapping Generations

  • Martine Quinzii
  • Michael Magill
  • Kristin Van Gaasback

    (Department of Economics, University of California Davis)

This paper studies a simple OLG model with production under the assumption that capital investment is completely irreversible: installed capital cannot be transformed back into consumption good nor transferred from one firm to another. Since firms cannot be dismantled at each generational change without loosing their value, their ownership is transmitted from generations to generations through a stock market. The paper shows that the financial price of a firm can be lower than the replacement value of its capital without creating arbitrage or dampening the incentives to invest. This possibility changes the long-run behavior of the equilibrium, but only for economies with under-accumulation. In the stock market dynamics these economies have two steady states, the Diamond steady state and the Golden Rule. The Diamond steady stable is locally saddle-point stable and can be reached by only one trajectory on which the financial price and replacement value of firms coincide at all times. All other trajectories on which there is a discount on equity converge (when they converge) to the Golden Rule which is locally stable: the discount on equity has the same effect as an increase of the savings of the young, which lowers the interest rate, and increases investment and wages at the next generation, a virtuous cycle which leads to the efficient long-run steady state. On all these trajectories the equity prices are larger than the fundamental value of future dividends and thus include a bubble component.

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Paper provided by University of California, Davis, Department of Economics in its series Working Papers with number 9913.

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Length: 33
Date of creation: 16 Jan 2003
Date of revision:
Handle: RePEc:cda:wpaper:99-13
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  1. Andrew Abel & Gregory N. Mankiw & Lawrence H. Summers & Richard Zeckhauser, . "Assessing Dynamic Efficiency: Theory and Evidence," Rodney L. White Center for Financial Research Working Papers 14-88, Wharton School Rodney L. White Center for Financial Research.
  2. Pingle, M. & Tesfatsion, Leigh S., 1998. "Active Intermediation in Overlapping Generations Economies with Production and Unsecured Debt," Staff General Research Papers 1228, Iowa State University, Department of Economics.
  3. Changyong Rhee, 1991. "Dynamic Inefficiency in an Economy with Land," Review of Economic Studies, Oxford University Press, vol. 58(4), pages 791-797.
  4. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
  5. Uzawa, H, 1969. "Time Preference and the Penrose Effect in a Two-Class Model of Economic Growth," Journal of Political Economy, University of Chicago Press, vol. 77(4), pages 628-52, Part II, .
  6. Robert E. Lucas & Jr., 1967. "Adjustment Costs and the Theory of Supply," Journal of Political Economy, University of Chicago Press, vol. 75, pages 321.
  7. Galor, Oded & Ryder, Harl E., 1989. "Existence, uniqueness, and stability of equilibrium in an overlapping-generations model with productive capital," Journal of Economic Theory, Elsevier, vol. 49(2), pages 360-375, December.
  8. Philippe Weil, 1987. "Confidence and the Real Value of Money in an Overlapping Generations Economy," The Quarterly Journal of Economics, Oxford University Press, vol. 102(1), pages 1-22.
  9. Manuel S. Santos & Michael Woodford, 1993. "Rational Asset Pricing Bubbles," Working Papers 9304, Centro de Investigacion Economica, ITAM.
  10. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
  11. Magill, M. & Quinzii, M., 1993. "Icomplete Markets Over an Infinite Horizon: Long-Lived Securities and Speculative Bubbles," Papers 9321, Southern California - Department of Economics.
  12. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 1(1), pages 15-29, February.
  13. Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, vol. 53(6), pages 1499-1528, November.
  14. Andrew B. Abel & N. Gregory Mankiw & Lawrence H. Summers & Richard J. Zeckhauser, 1989. "Assessing Dynamic Efficiency: Theory and Evidence," Review of Economic Studies, Oxford University Press, vol. 56(1), pages 1-19.
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