Some Macro Implications of Risk

Using the capital asset pricing model as the financial sector of a conventional rational-expectations macro model, an increase in expected inflation reduces the long-run capital stock, contrary to the usual result. This occurs because the induced fall in real balances increases equity's share in the market, raises equity's beta and discount rate, and reduces investment. Increases in the variance of disturbances to aggregate demand reduce the capital stock, while increases in the variance of inflation raise the stock. A proportionate increase in both variances reduces the captial stock. Copyright 1987 by Ohio State University Press.