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

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

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 in completeness 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18647.

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Date of creation: Dec 2012
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Handle: RePEc:nbr:nberwo:18647

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  1. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  2. James B. Bullard & George W. Evans & Seppo Honkapohja, 2007. "A model of near-rational exuberance," Working Papers, Federal Reserve Bank of St. Louis 2007-009, Federal Reserve Bank of St. Louis.
  3. Ricardo J. Caballero & Arvind Krishnamurthy, 2005. "Bubbles and Capital Flow Volatility: Causes and Risk Management," NBER Working Papers 11618, National Bureau of Economic Research, Inc.
  4. Roger E.A. Farmer & Carine Nourry & Alain Venditti, 2009. "Debt, deficits and finite horizons: the stochastic case," Working Papers halshs-00439336, HAL.
  5. Randall Wright & Guillaume Rocheteau, 2011. "Liquidity and Asset Market Dynamics," 2011 Meeting Papers 103, Society for Economic Dynamics.
  6. Emmanuel Farhi & Jean Tirole, 2012. "Bubbly Liquidity," Review of Economic Studies, Oxford University Press, vol. 79(2), pages 678-706.
  7. Jess Benhabib & Roger E.A. Farmer, 1992. "Indeterminacy and Increasing Returns," UCLA Economics Working Papers, UCLA Department of Economics 646, UCLA Department of Economics.
  8. Wen, Yi, 1998. "Capacity Utilization under Increasing Returns to Scale," Journal of Economic Theory, Elsevier, Elsevier, vol. 81(1), pages 7-36, July.
  9. Randall Wright & Chao Gu, 2011. "Endogenous Credit Cycles," 2011 Meeting Papers 373, Society for Economic Dynamics.
  10. Roger E.A. Farmer & Jang Ting Guo, 1992. "Real Business Cycles and the Animal Spirits Hypothesis," UCLA Economics Working Papers, UCLA Department of Economics 680, UCLA Department of Economics.
  11. Jess Benhabib & Pengfei Wang & Yi Wen, 2012. "Sentiments and aggregate demand fluctuations," Working Papers, Federal Reserve Bank of St. Louis 2012-039, Federal Reserve Bank of St. Louis.
  12. Malinvaud, Edmond, 1987. "The Overlapping Generations Model in 1947," Journal of Economic Literature, American Economic Association, vol. 25(1), pages 103-05, March.
  13. Nobuhiro Kiyotaki & John Moore, 1995. "Credit Cycles," NBER Working Papers 5083, National Bureau of Economic Research, Inc.
  14. Robert B. Barsky & J. Bradford De Long, 1992. "Why Does the Stock Market Fluctuate?," NBER Working Papers 3995, National Bureau of Economic Research, Inc.
  15. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
  16. John H. Cochrane, 2011. "Presidential Address: Discount Rates," Journal of Finance, American Finance Association, American Finance Association, vol. 66(4), pages 1047-1108, 08.
  17. Eugene F. Fama, 1963. "Mandelbrot and the Stable Paretian Hypothesis," The Journal of Business, University of Chicago Press, vol. 36, pages 420.
  18. Farmer, Roger E A, 2012. "Qualitative Easing: How it Works and Why it Matters," CEPR Discussion Papers, C.E.P.R. Discussion Papers 9153, C.E.P.R. Discussion Papers.
  19. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(2), pages 193-227, April.
  20. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, American Economic Association, vol. 98(4), pages 1211-44, September.
  21. Shell, Karl, 1971. "Notes on the Economics of Infinity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 79(5), pages 1002-11, Sept.-Oct.
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Blog mentions

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. 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, Turkish Economic Association, vol. 2(1), pages 41-77, January.
  2. Roger Farmer, 2014. "Asset Prices in a Lifecycle Economy," NBER Working Papers 19958, National Bureau of Economic Research, Inc.
  3. Dmitry Plotnikov, 2014. "Hysteresis in Unemployment and Jobless Recoveries," IMF Working Papers 14/77, International Monetary Fund.
  4. Farmer, Roger, 2013. "The Natural Rate Hypothesis: an idea past its sell-by date," Bank of England Quarterly Bulletin, Bank of England, vol. 53(3), pages 244-256.
  5. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.

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