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

  • S. Rao Aiyagari

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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  1. Pamela Labadie, 1989. "Stochastic inflation and the equity premium," Discussion Paper / Institute for Empirical Macroeconomics 12, Federal Reserve Bank of Minneapolis.
  2. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  3. Christopher Phelan & Robert M. Townsend, 1991. "Computing Multi-Period, Information-Constrained Optima," Review of Economic Studies, Oxford University Press, vol. 58(5), pages 853-881.
  4. Robert M. Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  5. Deaton, A., 1989. "Saving And Liquidity Constraints," Papers 153, Princeton, Woodrow Wilson School - Public and International Affairs.
  6. repec:tpr:qjecon:v:109:y:1994:i:3:p:659-84 is not listed on IDEAS
  7. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  8. Phelan, C. & Townsend, R.M., 1990. "Computing Multiperiod, Information-Constrained Optima," University of Chicago - Economics Research Center 90-13, Chicago - Economics Research Center.
  9. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
  10. N. Gregory Mankiw & Stephen P. Zeldes, 1990. "The Consumption of Stockholders and Non-Stockholders," NBER Working Papers 3402, National Bureau of Economic Research, Inc.
  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. 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.
  13. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  14. Andrew Atkeson & Robert E. Lucas, 1992. "On Efficient Distribution With Private Information," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 427-453.
  15. 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.
  16. 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.
  17. 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.).
  18. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  19. 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.
  20. 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.).
  21. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
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