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Coordination and correlation in Markov rational belief equilibria (*)

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Author Info

  • Mordecai Kurz

    (Department of Economics, Serra Street at Galvez, Stanford University, Stanford, CA 94305-6072, USA)

  • Martin Schneider

    (Department of Economics, Serra Street at Galvez, Stanford University, Stanford, CA 94305-6072, USA)

Abstract

This paper studies the effect of correlation in the rational beliefs of agents on the volatility of asset prices. We use the technique of generating variables to study stable and non-stationary processes needed to characterize rational beliefs. We then examine how the stochastic interaction among such variables affects the behavior of a wide class of Rational Belief Equilibria (RBE). The paper demonstrates how to construct a consistent price state space and then shows the existence of RBE for any economy for which such price state space is constructed. Next, the results are used to study the volatility of asset prices via numerical simulation of a two agents model. If beliefs of agents are uniformly dispersed and independent, we would expect heterogeneity of beliefs to have a limited impact on the fluctuations of asset prices. On the other hand, our results show that correlation across agents can have a complex and dramatic effect on the volatility of prices and thus can be the dominant factor in the fluctuation of asset prices. The mechanism generating this effect works through the clustering of beliefs in states of different levels of agreement. In states of agreement the conditional forecasts of the agents tend to fluctuate together inducing more volatile asset prices. In states of disagreement the conditional forecasts fluctuate in diverse directions tending to cancel each other's effect on market demand and resulting in reduced price volatility.

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Bibliographic Info

Article provided by Springer in its journal Economic Theory.

Volume (Year): 8 (1996)
Issue (Month): 3 ()
Pages: 489-520

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Handle: RePEc:spr:joecth:v:8:y:1996:i:3:p:489-520

Note: Received: July 25, 1995; revised version January 30, 1996
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Cited by:
  1. Orlando Gomes, 2004. "Heterogeneous Researchers in a Two-Sector Representative Consumer Economy," GE, Growth, Math methods 0409009, EconWPA.
  2. Mordecai Kurz, 1997. "Social States of Belief and the Determinants of the Equity Risk Premium in A Rational Belief Equilibrium," Working Papers 97026, Stanford University, Department of Economics.
  3. Kurz, Mordecai, 2008. "Beauty contests under private information and diverse beliefs: How different?," Journal of Mathematical Economics, Elsevier, vol. 44(7-8), pages 762-784, July.
  4. Kurz, Mordecai, 2006. "Beauty contests under private information and diverse beliefs: how different?," MPRA Paper 233, University Library of Munich, Germany, revised Apr 2006.
  5. Rieger, Jörg, 2014. "Financial Transaction Tax and Financial Market Stability with Diverse Beliefs," Working Papers 0563, University of Heidelberg, Department of Economics.
  6. Peter J. Hammond & Yeneng Sun, 2003. "Monte Carlo simulation of macroeconomic risk with a continuum of agents: the symmetric case," Economic Theory, Springer, vol. 21(2), pages 743-766, 03.
  7. Mordecai Kurz & Maurizio Motolese, 2007. "Diverse Beliefs and Time Variability of Risk Premia," Discussion Papers 06-044, Stanford Institute for Economic Policy Research.
  8. Kurz, Mordecai & Jin, Hehui & Motolese, Maurizio, 2005. "The role of expectations in economic fluctuations and the efficacy of monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 2017-2065, November.
  9. Mordecai Kurz & Hehui Jin & Maurizio Motolese, 2005. "Determinants of stock market volatility and risk premia," Annals of Finance, Springer, vol. 1(2), pages 109-147, 07.
  10. Mordecai Kurz, 2007. "Rational Diverse Beliefs and Economic Volatility," Discussion Papers 06-045, Stanford Institute for Economic Policy Research.
  11. Hiroyuki Nakata, 2007. "A Model of Financial Markets with Endogenously Correlated Rational Beliefs," Economic Theory, Springer, vol. 30(3), pages 431-452, March.
  12. Hiroyuki Nakata, 2013. "Welfare effects of short-sale constraints under heterogeneous beliefs," Economic Theory, Springer, vol. 53(2), pages 283-314, June.

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