Journal of Economic Dynamics and Control 17 (1993) 1-36. North-Holland Risk, the financial market, and macroeconomic equilibrium* Earl L. Grinols University of Illinois, Champaign, IL 61820, USA Stephen J. Turnovsky National Bureau of Economic Research University of Washington, Seattle, WA 98195, USA Received March 1991, final version received January 1992 Growing recognition of the importance of stock market phenomena to the real economy underscores the need for models linking exogenous uncertainty, asset market performance, and the rest of the economy in an optimizing framework without certainty equivalence. This paper constructs a three-agent model with continuous-time stochastic variables, uncertain private production and government expenditure, and forward-looking rational agents. The growth rate of output, physical capital accumulation, financial asset returns, and uncertain inflation are determined as functions of the exogenous uncertainty in the economy. Analysis of the model finds that increased risk associated with government policy often reverses in an explainable way the conventional comparative static predictions of nonstochastic macro models. I. Introduction The increased prominence of financial market volatility in recent years points to the need for a better understanding of the relationship between risk, financial markets, and real economic activity. Current macroeconomic theory is not very impressive in its ability to respond to these needs, and in fact is disappointingly limited in its capacity to deal adequately with risk in general equilibrium. This is because much macroeconomic theorizing as- *Earlier versions of this paper were presented to seminars at the University of Illinois, University of Washington, Washington State University, Summer Workshop at the University of Warwick, and at the World Congress of the Economic Society, Barcelona. We are grateful to various participants for their helpful comments. We also wish to acknowledge the constructive suggestions received from Martin Hellwig, as well as the referees and Associate Editor. 0165-1889/93/$05.00 © 1993--Elsevier Science Publishers B.V. All rights reserved