This paper analyzes the effects of technological risk on long-run growth when labor supply is elastic and production gives rise to a pollution externality. We show that the randomness of production, as well as the endogeneity of labor supply, affects the equilibrium solutions for the social planner and for the market economy. We analyze the effects of environmental policy, discuss conditions for an optimal policy, and find that the response of labor supply to changes in the model parameters and to variations in the policy instruments crucially depends on the volatility of output.

Stochastic models with economywide shocks imply that the welfare costs of aggregate volatility are negligible. Empirical evidence suggests that the volatility of idiosyncratic shocks is several times that of aggregate shocks. This paper introduces both types of shocks. We find that if in the process of eliminating aggregate risk the policymaker can reduce idiosyncratic risk by an amount suggested by available empirical evidence, the welfare gains from stabilization can become significant. The introduction of idiosyncratic risk has important implications for asset pricing, and in particular may reduce the risk-free rate substantially, through the precautionary savings motive. Many of our results are sensitive both to the degree of risk aversion and to the flexibility of labor supply. The paper highlights the trade-offs involved in analyzing the effects of risk on growth and welfare and on asset pricing, clarifying the need to examine these issues within a unified stochastic general equilibrium framework.

It has been argued that a clear understanding of the stochastic growth model can best be achieved by working out an approximate analytical solution. This paper follows that idea but streamlines the presentation of the loglinear approximate solution for the neoclassical model of capital accumulation. By focusing on the partial elasticity of capital stock with respect to its lag term, this paper is able to confirm analytically some conclusions based on numerical calculations in previous papers, and to clarify why a simpler solution arises in several special cases.

This paper analyzes productive government expenditure in a stochasticAK growth model. First, a centrally planned economy is characterized,emphasizing the trade-off between the effects of both deterministicand stochastic government expenditures on the equilibrium growth rateand its variance. Both the growth-maximizing and thewelfare-maximizing shares of government expenditure are derived andshown to depend (differentially) upon the degree of risk in theeconomy. Whereas production risk reduces the welfare-maximizingshare of government expenditure, it may either increase or decreasethe growth-maximizing share, depending upon the degree of riskaversion. Next, the stochastic equilibrium in a decentralized economyis derived. The first-best optimal tax structure is characterized andits dependence on risk is determined. The formal analysis issupplemented by some numerical simulations to assess the quantitativesignificance of risk and the divergence that this generates between thewelfare-maximizing and growth-maximizing size of government.