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Limited Market Participation and Volatility of Asset Prices

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  • Gale, D.
  • Allen, F.

Abstract

Traditional asset-pricing theories assume complete market participation, despite considerable empirical evidence that most investors participate in a limited number of markets. The authors show that once the participation decision is endogenized, market properties change dramatically. First, limited market participation can amplify the effect of liquidity trading relative to full participation; under certain circumstances, an arbitrarily small aggregate liquidity shock can cause significant price volatility. Second, there exist multiple equilibria with very different participation regimes and levels of asset-price volatility. Third, under plausible conditions the equilibria can be Pareto-ranked; the Pareto-preferred equilibrium is characterized by greater participation and lower volatility. Copyright 1994 by American Economic Association.
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Suggested Citation

  • Gale, D. & Allen, F., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 14-91, Wharton School - Weiss Center for International Financial Research.
  • Handle: RePEc:fth:pennif:14-91
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    References listed on IDEAS

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    1. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-987, December.
    2. Zeldes, Stephen P, 1989. "Consumption and Liquidity Constraints: An Empirical Investigation," Journal of Political Economy, University of Chicago Press, pages 305-346.
    3. Chah, Eun Young & Ramey, Valerie A & Starr, Ross M, 1995. "Liquidity Constraints and Intertemporal Consumer Optimization: Theory and Evidence from Durable Goods," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(1), pages 272-287, February.
    4. Avner Bar-Ilan & Alan S. Blinder, 1988. "Consumer Durables and the Optimality of Usually Doing Nothing," NBER Working Papers 2488, National Bureau of Economic Research, Inc.
    5. Pok-Sang Lam, 1991. "Permanent Income, Liquidity, and Adjustments of Automobile Stocks: Evidence from Panel Data," The Quarterly Journal of Economics, Oxford University Press, vol. 106(1), pages 203-230.
    6. Andrew S. Caplin & Daniel F. Spulber, 1987. "Menu Costs and the Neutrality of Money," The Quarterly Journal of Economics, Oxford University Press, vol. 102(4), pages 703-725.
    7. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-257, August.
    8. Ben S. Bernanke, 1984. "Permanent Income, Liquidity, and Expenditure on Automobiles: Evidence from Panel Data," The Quarterly Journal of Economics, Oxford University Press, vol. 99(3), pages 587-614.
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    Keywords

    pricing ; investments ; economic equilibrium;

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