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Speculation and Financial Wealth Distribution Under Belief Heterogeneity

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  • Dan Cao

Abstract

Under limited commitment that prevents agents from pledging their future non‐financial wealth, agents with incorrect beliefs always survive by holding on to their non‐financial wealth. Friedman's () market selection hypothesis suggests that their financial wealth trends towards zero in the long run. However, I present a dynamic general equilibrium model with incomplete markets due to collateral constraints and show that the hypothesis depends on the degree of market incompleteness. When markets are more incomplete, over‐optimistic agents not only survive but also prosper by speculation. Stricter margin requirements protect the wealth of the optimists and thereby increase asset price volatility.

Suggested Citation

  • Dan Cao, 2018. "Speculation and Financial Wealth Distribution Under Belief Heterogeneity," Economic Journal, Royal Economic Society, vol. 128(614), pages 2258-2281, September.
    • Handle: RePEc:wly:econjl:v:128:y:2018:i:614:p:2258-2281
    DOI: 10.1111/ecoj.12519
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    Citations

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    Cited by:

    1. Saki Bigio & Eduardo Zilberman, 2020. "Speculation-Driven Business Cycles," Working Papers Central Bank of Chile 865, Central Bank of Chile.
    2. Gregor Boehl & Cars Hommes, 2021. "Rational vs. Irrational Beliefs in a Complex World," CRC TR 224 Discussion Paper Series crctr224_2021_287, University of Bonn and University of Mannheim, Germany.
    3. Cao, Dan & Lorenzoni, Guido & Walentin, Karl, 2019. "Financial frictions, investment, and Tobin’s q," Journal of Monetary Economics, Elsevier, vol. 103(C), pages 105-122.
    4. Norman, Thomas W.L., 2020. "Market selection with an endogenous state," Journal of Mathematical Economics, Elsevier, vol. 91(C), pages 51-59.
    5. Chabakauri, Georgy & Han, Brandon Yueyang, 2020. "Collateral constraints and asset prices," Journal of Financial Economics, Elsevier, vol. 138(3), pages 754-776.
    6. Cao, Dan & Evans, Martin & Lua, Wenlan, 2020. "Real Exchange Rate Dynamics Beyond Business Cycles," MPRA Paper 99054, University Library of Munich, Germany, revised 10 Mar 2020.
    7. Dan Cao & Wenlan Luo & Guangyu Nie, 2023. "Global GDSGE Models," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 51, pages 199-225, December.
    8. Dindo, Pietro, 2019. "Survival in speculative markets," Journal of Economic Theory, Elsevier, vol. 181(C), pages 1-43.
    9. Johannes Brumm & Michael Grill & Felix Kubler & Karl Schmedders, 2023. "Re-use of collateral: Leverage, volatility, and welfare," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 47, pages 19-46, January.
    10. Phelan, Gregory & Toda, Alexis Akira, 2019. "Securitized markets, international capital flows, and global welfare," Journal of Financial Economics, Elsevier, vol. 131(3), pages 571-592.
    11. Laura Bakkensen & Toan Phan & Russell Wong, 2023. "Leveraging the Disagreement on Climate Change: Theory and Evidence," Working Paper 23-01, Federal Reserve Bank of Richmond.
    12. Giulio Bottazzi & Pietro Dindo & Daniele Giachini, 2019. "Momentum and reversal in financial markets with persistent heterogeneity," Annals of Finance, Springer, vol. 15(4), pages 455-487, December.
    13. Cao, Dan, 2020. "Recursive equilibrium in Krusell and Smith (1998)," Journal of Economic Theory, Elsevier, vol. 186(C).

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