SAFE Working Paper No. 124

The Intended and Unintended Consequences of Financial-Market Regulations: A General Equilibrium Analysis

In a production economy with trade in financial markets motivated by the de- sire to share labor-income risk and to speculate, we show that speculation increases volatility of asset returns and investment growth, increases the equity risk premium, and reduces welfare. Regulatory measures, such as constraints on stock positions, borrowing constraints, and the Tobin tax have similar effects on financial and macroeconomic variables. Borrowing limits and a financial transaction tax improve welfare because they substantially reduce speculative trading without impairing excessively risk-sharing trades.