Trading Frenzy and Its Impact on Real Investment
33 Pages Posted: 17 Mar 2009 Last revised: 7 Dec 2011
Date Written: May 22, 2009
We study a model where a capital provider learns from the price of a firm's stock when making a decision how much capital to provide for new investment. The efficiency of the investment decision and the volatility of prices and investments depend crucially on the strategic interaction among speculators in the market. We show that speculators almost always coordinate either too much or too little, reducing the effectiveness of the financial market in guiding the investment decision. Our model gives rise to phenomena similar to what has happened in the recent crisis where speculators coordinate to 'run' on a stock, pushing down its price in a way that deprives the firm of capital and exacerbates the underlying problem.
Keywords: Coordination, Asset price, Feedback, Excess Volatility
JEL Classification: G12, E4, C7
Suggested Citation: Suggested Citation