The Real Effects of Financial Markets

36 Pages Posted: 31 Dec 2011 Last revised: 2 Jun 2023

See all articles by Philip Bond

Philip Bond

University of Washington - Michael G. Foster School of Business

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department ; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: December 2011

Abstract

A large amount of activity in the financial sector occurs in secondary financial markets, where securities are traded among investors without capital flowing to firms. The stock market is the archetypal example, which in most developed economies captures a lot of attention and resources. Is the stock market just a side show or does it affect real economic activity? In this article, we discuss the potential real effects of financial markets that stem from the informational role of market prices. We review the theoretical literature and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators' trading behavior. We make two main points. First, we argue that a new definition of price efficiency is needed to account for the extent to which prices reflect information useful for the efficiency of real decisions (rather than the extent to which they forecast future cash flows). Second, incorporating the feedback effect into models of financial markets can explain various market phenomena that otherwise seem puzzling. Finally, we review empirical evidence on the real effects of secondary financial markets.

Suggested Citation

Bond, Philip and Edmans, Alex and Goldstein, Itay, The Real Effects of Financial Markets (December 2011). NBER Working Paper No. w17719, Available at SSRN: https://ssrn.com/abstract=1977769

Philip Bond (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
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Alex Edmans

London Business School - Institute of Finance and Accounting ( email )

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European Corporate Governance Institute (ECGI) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

London
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Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
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Philadelphia, PA 19104
United States
215-746-0499 (Phone)

National Bureau of Economic Research (NBER) ( email )

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