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Journal of Monetary Economics (forthcoming)
In a production economy with trade in financial markets motivated by the desire to share labor-income risk and to speculate, the authors 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. However, borrowing constraints and the Tobin tax are more successful than constraints on stock positions at improving welfare because they substantially reduce speculative trading without impairing excessively risk-sharing trades.