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The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World

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  • Farmer, Roger E A
  • Nourry, Carine
  • Venditti, Alain

Abstract

Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. Our work provides such an explanation. We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents' discount factors. We show that these two minor and realistic changes to the timeless Arrow-Debreu paradigm are sufficient to invalidate the implication that competitive financial markets efficiently allocate risk. Our work demonstrates that financial markets, by their very nature, cannot be Pareto efficient, except by chance. Although individuals in our model are rational; markets are not.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9283.

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Date of creation: Jan 2013
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Handle: RePEc:cpr:ceprdp:9283

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Keywords: asset pricing; efficient markets; excess volatility;

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References

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  1. Emmanuel Farhi & Jean Tirole, 2012. "Bubbly Liquidity," Review of Economic Studies, Oxford University Press, vol. 79(2), pages 678-706.
  2. Farmer, Roger E A, 2012. "Qualitative Easing: How it Works and Why it Matters," CEPR Discussion Papers 9153, C.E.P.R. Discussion Papers.
  3. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  4. Robert B. Barsky & J. Bradford De Long, 1992. "Why Does the Stock Market Fluctuate?," NBER Working Papers 3995, National Bureau of Economic Research, Inc.
  5. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2006. "Bubbles and capital flow volatility: Causes and risk management," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 35-53, January.
  6. Wen, Yi, 1998. "Capacity Utilization under Increasing Returns to Scale," Journal of Economic Theory, Elsevier, vol. 81(1), pages 7-36, July.
  7. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  8. Jess Benhabib & Pengfei Wang & Yi Wen, 2012. "Sentiments and aggregate demand fluctuations," Working Papers 2012-039, Federal Reserve Bank of St. Louis.
  9. Benhabib Jess & Farmer Roger E. A., 1994. "Indeterminacy and Increasing Returns," Journal of Economic Theory, Elsevier, vol. 63(1), pages 19-41, June.
  10. Farmer Roger E. A. & Guo Jang-Ting, 1994. "Real Business Cycles and the Animal Spirits Hypothesis," Journal of Economic Theory, Elsevier, vol. 63(1), pages 42-72, June.
  11. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  12. Randall Wright & Guillaume Rocheteau, 2011. "Liquidity and Asset Market Dynamics," 2011 Meeting Papers 103, Society for Economic Dynamics.
  13. Roger Farmer & Carine Nourry & Alain Venditti, 2009. "Debt, Deficits and Finite Horizons: The Stochastic Case," NBER Working Papers 15025, National Bureau of Economic Research, Inc.
  14. Chao Gu & Randall Wright, 2011. "Endogenous credit cycles," Working Papers 689, Federal Reserve Bank of Minneapolis.
  15. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
  16. James B. Bullard & George W. Evans & Seppo Honkapohja, 2007. "A model of near-rational exuberance," Working Papers 2007-009, Federal Reserve Bank of St. Louis.
  17. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
  18. John H. Cochrane, 2011. "Presidential Address: Discount Rates," Journal of Finance, American Finance Association, vol. 66(4), pages 1047-1108, 08.
  19. Eugene F. Fama, 1963. "Mandelbrot and the Stable Paretian Hypothesis," The Journal of Business, University of Chicago Press, vol. 36, pages 420.
  20. Shell, Karl, 1971. "Notes on the Economics of Infinity," Journal of Political Economy, University of Chicago Press, vol. 79(5), pages 1002-11, Sept.-Oct.
  21. Malinvaud, Edmond, 1987. "The Overlapping Generations Model in 1947," Journal of Economic Literature, American Economic Association, vol. 25(1), pages 103-05, March.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World
    by Christian Zimmermann in NEP-DGE blog on 2013-03-15 19:50:06
Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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Cited by:
  1. Roger Farmer, 2014. "Asset Prices in a Lifecycle Economy," NBER Working Papers 19958, National Bureau of Economic Research, Inc.
  2. Farmer, Roger E A, 2013. "The Natural Rate Hypothesis: An idea past its sell-by-date," CEPR Discussion Papers 9580, C.E.P.R. Discussion Papers.
  3. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.
  4. Beniamino Moro, 2013. "The Run On Repo and the Liquidity Shortage Problems of the Current Global Financial Crisis: Europe vs. The US," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 2(1), pages 41-77, January.
  5. Dmitry Plotnikov, 2014. "Hysteresis in Unemployment and Jobless Recoveries," IMF Working Papers 14/77, International Monetary Fund.

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