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Collateral Shortages, Asset Price and Investment Volatility with Heterogeneous Beliefs

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.

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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
Handle: RePEc:geo:guwopa:gueconwpa~11-11-01
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Georgetown University Department of Economics Washington, DC 20057-1036

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Web page: http://econ.georgetown.edu/
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Order Information: Postal: Roger Lagunoff Professor of Economics Georgetown University Department of Economics Washington, DC 20057-1036
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  1. Lucas, Robert E, Jr & Prescott, Edward C, 1971. "Investment Under Uncertainty," Econometrica, Econometric Society, vol. 39(5), pages 659-681, September.
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  3. Karl Schmedders & Felix Kubler, 2012. "Life-Cycle Portfolio Choice, the Wealth Distribution and Asset Prices," 2012 Meeting Papers 536, Society for Economic Dynamics.
  4. Wei Xiong & Hongjun Yan, 2010. "Heterogeneous Expectations and Bond Markets," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1433-1466, April.
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  7. Weerachart Kilenthong, 2011. "Collateral premia and risk sharing under limited commitment," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 46(3), pages 475-501, April.
  8. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
  9. Tarek Coury & Emanuela Sciubba, 2012. "Belief heterogeneity and survival in incomplete markets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 49(1), pages 37-58, January.
  10. Kehoe, Timothy J & Levine, David K, 2001. "Liquidity Constrained Markets versus Debt Constrained Markets," Econometrica, Econometric Society, vol. 69(3), pages 575-598, May.
  11. Jianjun Miao, 2004. "Competitive Equilibria of Economies with a Continuum of Consumers and Aggregate Shocks," CEMA Working Papers 460, China Economics and Management Academy, Central University of Finance and Economics.
  12. Brumm, Johannes & Grill, Michael & Kubler, Felix & Schmedders, Karl, 2013. "Collateral requirements and asset prices," Discussion Papers 44/2013, Deutsche Bundesbank, Research Centre.
  13. Fernando Alvarez & Urban J. Jermann, "undated". "Quantitative Asset Pricing Implications of Endogenous Solvency Constraints," Rodney L. White Center for Financial Research Working Papers 10-99, Wharton School Rodney L. White Center for Financial Research.
  14. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1988. "The Survival of Noise Traders in Financial Markets," NBER Working Papers 2715, National Bureau of Economic Research, Inc.
  15. Leonid Kogan & Stephen Ross & Jiang Wang & Mark Westerfield, 2003. "The Price Impact and Survival of Irrational Traders," NBER Working Papers 9434, National Bureau of Economic Research, Inc.
  16. Per Krusell & Anthony A. Smith, Jr., "undated". "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  17. Beker, Pablo & Chattopadhyay, Subir, 2010. "Consumption dynamics in general equilibrium: A characterisation when markets are incomplete," Journal of Economic Theory, Elsevier, vol. 145(6), pages 2133-2185, November.
  18. Felix Kubler & Karl Schmedders, 2003. "Stationary Equilibria in Asset-Pricing Models with Incomplete Markets and Collateral," Econometrica, Econometric Society, vol. 71(6), pages 1767-1793, November.
  19. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
  20. Araújo, Aloísio & Kubler, Felix & Schommer, Susan, 2012. "Regulating collateral-requirements when markets are incomplete," Journal of Economic Theory, Elsevier, vol. 147(2), pages 450-476.
  21. Guido Lorenzoni & Karl Walentin, 2006. "Financial Frictions, Investment and Tobin's q," 2006 Meeting Papers 844, Society for Economic Dynamics.
  22. Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, vol. 40(2), pages 289-303, March.
  23. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715, Cowles Foundation for Research in Economics, Yale University.
  24. Alvaro Sandroni, 2000. "Do Markets Favor Agents Able to Make Accurate Predicitions?," Econometrica, Econometric Society, vol. 68(6), pages 1303-1342, November.
  25. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
  26. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-1244, September.
  27. J. Michael Harrison & David M. Kreps, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, Oxford University Press, vol. 92(2), pages 323-336.
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