The intended and unintended consequences of financial-market regulations: A general-equilibrium analysis

• Speculation increases asset-return and real-investment volatility, reducing welfare.
• Short-sale and borrowing constraints and Tobin tax used to mitigate these effects.
• All three regulatory measures have similar effects on financial and macro variables.
• But, the borrowing constraint is most effective at improving welfare.
• This is because it reduces speculation without substantially impairing risk-sharing.

In a production economy with trade in financial markets motivated by the desire to share labor-income risk and to speculate, we 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.