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Collateral Shortages, Asset Price and Investment Volatility with Heterogeneous Beliefs

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    Abstract

    The recent economic crisis highlights the role of financial markets in allowing economic agents, including prominent banks, to speculate on the future returns of different financial assets, such as mortgage-backed securities. This paper in troduces a dynamic general equilibrium model with aggregate shocks, potentially incomplete markets and heterogeneous agents to investigate this role of financial markets. In addition to their risk aversion and endowments, agents differ in their beliefs about the future exogenous states (aggregate and idiosyncratic) of the economy. This difference in beliefs induces them to take large bets under frictionless complete financial markets, which enable agents to leverage their future wealth. Consequently, as hypothesized by Friedman (1953), under complete markets, agents with incorrect beliefs will eventually be driven out of the markets. In this case, they also have no influence on asset prices and real investment in the long run. In contrast, I show that under incomplete markets generated by collateral constraints, agents with heterogeneous (potentially incorrect) beliefs survive in the long run and their speculative activities permanently drive up asset price volatility and real investment volatility. I also show that collateral constraints are always binding even if the supply of collateral assets endogenously responds to their price. I use this framework to study the effects of different types of regulations and the distribution of endowments on leverage, asset price volatility and investment. Lastly, the analytical tools developed in this framework enable me to prove the existence of the "generalized" recursive equilibrium in Krusell and Smith (1998) with a finite number of agents. Classification-JEL Codes:

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    Bibliographic Info

    Paper provided by Georgetown University, Department of Economics in its series Working Papers with number gueconwpa~11-11-01.

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    Date of creation: 01 Nov 2011
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    Handle: RePEc:geo:guwopa:gueconwpa~11-11-01

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    Postal: Georgetown University Department of Economics Washington, DC 20057-1036
    Phone: 202-687-6074
    Fax: 202-687-6102
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    Web page: http://econ.georgetown.edu/

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    Postal: Marcia Suss Administrative Officer Georgetown University Department of Economics Washington, DC 20057-1036
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    Web: http://econ.georgetown.edu/

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    Cited by:
    1. GOTTARDI, Piero & KUBLER, Felix, 2012. "Dynamic Competitive Economies with Complete Markets and Collateral Constraints," Economics Working Papers ECO2012/17, European University Institute.
    2. Patrick A. Pintus & Jacek Suda, 2013. "Learning Leverage Shocks and the Great Recession," AMSE Working Papers 1333, Aix-Marseille School of Economics, Marseille, France, revised 05 Jun 2013.
    3. Sonja Brangewitz & Gael Giraud, 2011. "Learning in Infinite Horizon Strategic Market Games with Collateral and Incomplete Information," Working Papers 456, Bielefeld University, Center for Mathematical Economics.
    4. Patrick A. Pintus & Jacek Suda, 2014. "Learning Financial Shocks and the Great Recession," Working Papers halshs-00830480, HAL.
    5. Sonja Brangewitz & Gaël Giraud, 2012. "Learning by Trading in Infinite Horizon Strategic Market Games with Default," Documents de travail du Centre d'Economie de la Sorbonne 12062r, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne, revised Oct 2013.

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