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A Theory of Pseudo Wealth

Guzman, Martin; Stiglitz, Joseph E.

This chapter presents a theory of pseudo-wealth that can account for two important situations that arise in times of recession: (i) There are often large changes in the state of the economy with no commensurate changes in the state variables that describe it; and (ii) There are often persistent booms where (for plausible preferences) aggregate consumption seems excessive, beyond levels that are consistent with the feasibility constraints, or persistent busts with underutilization of the factors of production of the economy. With heterogeneous beliefs and a market for exploiting those differences in beliefs, pseudo-wealth will be created— that is, the sum of expected wealth of all the individuals will be larger than what is feasible for the society. Under some conditions, those perceptions will lead to higher spending than in a world with common beliefs. If those differences in beliefs disappear, pseudo-wealth will disappear, leading to adjustments in behavior that amplify the initial decrease in expected wealth. We also show that completing markets can lead to ambiguous results in terms of welfare. They can induce the creation of pseudo-wealth that makes everyone better off ex-ante (that is, everyone’s ex ante expected utility is increased), but that can lead to lower levels of production in every period—as agents wish to work less when they feel wealthier, and the adjustments that follow the disappearance of pseudo-wealth will also lead to lower levels of production. Finally, the chapter elaborates on the idea that macroeconomic adjustments may be destabilizing. Policies that diminish wage flexibility but have positive distributive effects could enhance the performance of the economy. More generally, this chapter describes the main intuitions of the results obtained in an agenda developed in Guzman and Stiglitz (2014, 2015).

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Title
Contemporary Issues in Macroeconomics: Lessons from the Crisis and Beyond
Publisher
Palgrave Macmillan

More About This Work

Academic Units
Economics
Business
Published Here
April 15, 2019
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