The Social Cost of Near-Rational Investment
Tarek A. Hassan
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Thomas M. Mertens
Federal Reserve Bank of San Francisco
May 10, 2014
AFA 2012 Chicago Meetings Paper
We show that the stock market may fail to aggregate information even if it appears to be efficient and that the resulting decrease in the information content of stock prices may drastically reduce welfare. We solve a macroeconomic model in which information about fundamentals is dispersed and households make small, correlated errors around their optimal investment policies. As information aggregates in the market, these errors amplify and crowd out the information content of stock prices. When stock prices reflect less information, the volatility of stock returns rises. The increase in volatility makes holding stocks unattractive, distorts the long-run level of capital accumulation, and causes costly (first-order) distortions in the long-run level of consumption.
Number of Pages in PDF File: 70
Keywords: Near-rationality, investment, capital accumulation
JEL Classification: E62, G11, O16
Date posted: March 18, 2008 ; Last revised: January 11, 2016
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