'Irrational exuberance' and capital flows for the US New Economy: a simple global model

In a stylized and analytically tractable model of the global economy, we first calculate the Pareto improvement when a country experiencing a favourable supply side shock consumes more against expected future output and spreads the risk by selling shares. With capital inflows to finance the 'New Economy' significantly exceeding the current account deficit, we then show that selling shares globally at inflated prices-due to 'irrational exuberance' and|or distorted corporate incentives-can generate significant international transfers when the asset bubble bursts. Our analysis complements econometric studies showing how much the European economy was affected when the US asset boom ended. Copyright © 2007 John Wiley & Sons, Ltd.