Intermediation, The Stock Market and Intergenerational Transfers XII ISER Workshop on General Equilibrium: Problems, Prospects and Alternatives

Roughly speaking there are two classes of general equilibrium models which explicitly recognize that the future is open ended: the ̄rst, simplest and most idealized, views agents as being in ̄nitely lived|they are all permanently on stage together. With a complete set of markets such an economy leads to an e±cient outcome: in essence all contingencies can be traded out at an initial date and the future unfolds in a preordained way thereafter. The second, more realistic framework, recognizes that agents are ̄nitely lived|agents in any generation are on stage for only a transient interval of time and are replaced by the agents of the next generation. In this latter model, markets face more serious problems for co-ordinating agents decisions over time. In this paper we use the simplest overlapping generations (OLG) model with production to study how capital markets co-ordinate decisions of consumers and the investment decisions of ̄rms, their joint decisions leading to a path of capital accumulation for the economy. The distilled essence of our message is best understood by ̄rst looking at the simplest model of an overlapping generations exchange economy, namely the canonical model of Allais (1947) and Samuelson (1958), as analyzed and interpreted in the elegant paper of Gale (1973). The ̄rst principle that we draw from this preliminary model is that economies can be classi ̄ed into one of two types depending on the direction (sign) of the transfers between generations at the Golden Rule (positive if from young to old, negative if from old to young) and that the long-run dynamic behavior of an economy can be predicted once the sign of these transfers is known. The second principle is that ̄nancial markets lead to long-run e±ciency for economies with negative transfers, but do not lead to long-run e±ciency for economies with positive transfers, i.e. ̄nancial markets can successfully transfer income backwards, but not forwards. We then consider the simplest model of an overlapping generations production economy, namely the classic model of Diamond (1965), which has become one of the basic workhorses of modern macroeconomics. Many current policy debates { for example on the nature and role of the social security system { draw heavily on the insights of this model, and it is here that our message comes