Volatile Stock Markets: Equilibrium Computation and Policy Analysis
52 Pages Posted: 18 Mar 2009 Last revised: 22 Nov 2011
Date Written: November 21, 2011
This paper studies the benefits of leaning-against-the-wind policies in the presence of inefficient stock markets. It incorporates observed levels of volatility in stock returns into a standard general equilibrium model and finds large welfare gains from stabilizing policies. Stock prices in this model aggregate information about fundamentals which is dispersed in the economy but also reflect noise stemming from correlated distortions in beliefs. Dispersion of information allows arbitrarily small distortions in beliefs to generate large volatility in returns and renders arbitrage infeasible. The government cannot observe whether a given stock price movement originates from information or noise. As a normative result, stock return stabilizing policies lead to a higher level of consumption: a fall in the risk premium lowers the marginal product of capital and raises the capital stock and production. History-dependent policies may improve the information content of prices and result in even higher welfare gains. To solve the model, this paper develops a novel solution method for nonlinear models with dispersed information which can be applied to a large class of dynamic general equilibrium models.
JEL Classification: C63, E44, E61, G01, G11, G18, H21
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