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Explaining financial market facts: the importance of incomplete markets and transaction costs

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  • S. Rao Aiyagari

Abstract

In this article, I suggest that incomplete markets and transaction costs are crucial for explaining the high equity premium and the low risk-free rate. I first demonstrate the failure of the complete frictionless markets model in explaining these return puzzles and then show how introducing incomplete markets and transaction costs can lead to success. Additionally, I explain how these features lead to predictions concerning individual consumptions, wealths, portfolios, and asset market transactions that are in better agreement with the facts than the predictions of the complete frictionless markets model.

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Article provided by Federal Reserve Bank of Minneapolis in its journal Quarterly Review.

Volume (Year): (1993)
Issue (Month): Win ()
Pages: 17-31

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Handle: RePEc:fip:fedmqr:y:1993:i:win:p:17-31:n:v.17no.1
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Keywords: Interest rates;

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  1. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April.
  2. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  3. Deaton, Angus, 1991. "Saving and Liquidity Constraints," Econometrica, Econometric Society, vol. 59(5), pages 1221-48, September.
  4. James M. Nason, 1988. "The equity premium and time-varying risk behavior," Finance and Economics Discussion Series 11, Board of Governors of the Federal Reserve System (U.S.).
  5. Kessler, Denis & Wolff, Edward N, 1991. "A Comparative Analysis of Household Wealth Patterns in France and the United States," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 37(3), pages 249-66, September.
  6. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  7. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  8. S. Rao Aiyagari & Mark Gertler, 1990. "Asset Returns with Transactions Cost and Uninsured Risk: A Stage III Exercise," NBER Working Papers 3481, National Bureau of Economic Research, Inc.
  9. Phelan, Christopher & Townsend, Robert M, 1991. "Computing Multi-period, Information-Constrained Optima," Review of Economic Studies, Wiley Blackwell, vol. 58(5), pages 853-81, October.
  10. Barsky, Robert B & Mankiw, N Gregory & Zeldes, Stephen P, 1986. "Ricardian Consumers with Keynesian Propensities," American Economic Review, American Economic Association, vol. 76(4), pages 676-91, September.
  11. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
  12. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  13. Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March.
  14. Pamela Labadie, 1989. "Stochastic inflation and the equity premium," Discussion Paper / Institute for Empirical Macroeconomics 12, Federal Reserve Bank of Minneapolis.
  15. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  16. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
  17. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  18. Atkeson, Andrew & Lucas, Robert E, Jr, 1992. "On Efficient Distribution with Private Information," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 427-53, July.
  19. Christopher D. Carroll, 1991. "Buffer stock saving and the permanent income hypothesis," Working Paper Series / Economic Activity Section 114, Board of Governors of the Federal Reserve System (U.S.).
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Cited by:

  1. Mendoza, Enrique G. & Smith, Katherine A., 2006. "Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices," Journal of International Economics, Elsevier, vol. 70(1), pages 82-114, September.
  2. V. Martins-da-Rocha & Yiannis Vailakis, 2010. "Financial markets with endogenous transaction costs," Economic Theory, Springer, vol. 45(1), pages 65-97, October.
  3. Cristina Arellano & Enrique Mendoza, 2002. "Fricciones crediticias y 'paradas repentinas' en pequeñas economías abiertas: un marco de equilibrio del ciclo económico para crisis en mercados emergentes," Research Department Publications 4308, Inter-American Development Bank, Research Department.
  4. V. Filipe MARTINS-DA-ROCHA & YIANNIS VAILAKIS, 2008. "Endogenous Transaction Costs," Discussion Papers 0810, Exeter University, Department of Economics.
  5. Cristina Arellano & Enrique G. Mendoza, 2002. "Credit Frictions and "Sudden Stop" in Small Open Economies: An Equilibrium Business Cycle Framework for Emerging Markets Crises," IDB Publications (Working Papers) 6499, Inter-American Development Bank.
  6. B. Ravikumar & Enchuan Shao, 2010. "Search Frictions and Asset Price Volatility," Working Papers 10-1, Bank of Canada.
  7. Donadelli, Michael & Prosperi, Lorenzo, 2012. "On the role of liquidity in emerging markets stock prices," Research in Economics, Elsevier, vol. 66(4), pages 320-348.
  8. Teresa Garcia-Milà & Albert Marcet & Eva Ventura, 1995. "Supply side interventions and redistribution," Economics Working Papers 115, Department of Economics and Business, Universitat Pompeu Fabra.
  9. Andrés F. Arias, . "Banking Productivity and Economic Fluctuations: Colombia 1998-2000," Borradores de Economia 192, Banco de la Republica de Colombia.
  10. Andrés Felipe Arias, 2001. "Banking Productivity And Economic Fluctuations: Colombia 1998-2000," BORRADORES DE ECONOMIA 002050, BANCO DE LA REPÚBLICA.

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