This paper develops a continuous-time stochastic model in which international risk-sharing can yield substantial welfare gains through its effect on expected consumption growth. The mechanism linking global diversification to growth is an attendant world portfolio shift from safe low-yield capital to riskier high-yield capital. The presence of these two types of capital captures the idea that growth depends on the availability of an ever-increasing array of specialized, hence inherently risky, production inputs. Calibration exercises using consumption and stock-market data imply that most countries reap large steady-state welfare gains from global financial integration.

Several puzzling aspects of the behavior of United States stock prices may be explained by the presence of a specific type of rational bubble that depends exclusively on aggregate dividends. We call bubbles of this type "intrinsic" bubbles because they derive all of their variability from exogenous economic fundamentals and none from extraneous factors. Intrinsic bubbles provide a more plausible empirical account of deviations from present-value pricing than do the traditional examples of rational bubbles. Their explanatory potential comes partly from their ability to generate persistent deviations that appear to be relatively stable over long periods.

Do global current account imbalances still matter in a world of deep international financial markets where gross two-way financial flows often dwarf the net flows measured in the current account? Contrary to a complete markets or “consenting adults” view of the world, large current account imbalances, while very possibly warranted by fundamentals and welcome, can also signal elevated macroeconomic and financial stresses, as was arguably the case in the mid-2000s. Furthermore, the increasingly big valuation changes in countries’ net international investment positions, while potentially important in risk allocation, cannot be relied upon systematically to offset the changes in national wealth implied by the current account. The same factors that dictate careful attention to global imbalances also imply, however, that data on gross international financial flows and positions are central to any assessment of financial stability risks. The balance sheet mismatches of leveraged entities provide the most direct indicators of potential instability, much more so than do global imbalances, though the imbalances may well be a symptom that deeper financial threats are gathering.

Speculative attacks on a pegged exchange rate must sometimes occur ifasset-price paths are to be free of abnormal profit opportunities. Suchattacks are fully rational, as they reflect the market's response to aregime breakdown that is inevitable. The authors shows that under someexpectations about policy, balance-of-payments crises can also be purely self-fulfilling events. In such cases even a permanently viableregime may collapse, and the economy will possess multiple equilibriacorresponding to different subjective assessments of the probability ofa crisis. The behavior of the domestic interest rate will naturally reflect the possibility of a speculative attack.

This paper examines the effects of ex-change-rate policies when individuals maximize lifetime utility on the basis of rational expectations about the future. The economy studied is one in which the authorities allow free mobility of capital under a crawling-peg exchange-rate regime. Many industrializing economies have adopted a crawling peg as a means of reconciling disparate inflation rates at home and abroad, and some recent efforts to use the rate of crawl as an instrument of anti-inflation policy have attracted considerable interest (see Carlos Diaz Alejandro). Tools similar to those employed here have been applied by Guillermo Calvo (forthcoming) to study this type of exchange-rate management under conditions of capital immobility.

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. We show that even were this the case, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. As we also demonstrate, however, this same reasoning implies that open-market operations will be beneficial for stabilization as well, even when the economy is expected to remain mired in a liquidity trap for some time. Thus, the microeconomic fiscal benefits of open-market operations in a liquidity trap go hand in hand with standard macroeconomic objectives. Motivated by Japan’s recent economic experience, we use a dynamic general-equilibrium model to assess the welfare impact of open-market operations for an economy in Japan’s predicament. We argue Japan can achieve a substantial welfare improvement through large open-market purchases of domestic government debt.