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Pseudo-wealth Fluctuations and Aggregate Demand Effects

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This paper presents a theory of pseudo-wealth in a model that displays aggregate demand externalities.

With heterogeneous beliefs and a market for exploiting those differences in beliefs, pseudo-wealth will be created–i.e. the sum of expected wealth of all the individuals will be larger than what it is feasible for the society. Under some conditions, those perceptions will lead to larger levels of consumption of (tradable and non-tradable) goods, leisure, and borrowing than in a world with common beliefs. If those differences in beliefs disappear, pseudo-wealth will disappear, leading to adjustments in behavior that amplify the initial decrease in expected wealth. That is, we provide a simple general equilibrium model in which the destruction of pseudo-wealth amplifies the effects of the initial disturbance, leading to large decreases in economic activity. Importantly, this downturn is not associated with any change in the state variables that describe the economy.

More generally, the paper shows that completing markets (in this case by creating a market for bets) may imply lower output both in the present and in the future, raising unsettling questions on criteria for welfare analysis.