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The Real Effects of Financial Markets

Annual Review of Financial Economics 4, 339-360, October 2012

35 Pages Posted: 24 Dec 2011 Last revised: 20 Dec 2013

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

Multiple version iconThere are 3 versions of this paper

Date Written: March 1, 2012

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.

Keywords: Feedback effects, financial efficiency, market efficiency, real efficiency

JEL Classification: G12, G14, G31, G32, G34

Suggested Citation

Bond, Philip and Edmans, Alex and Goldstein, Itay, The Real Effects of Financial Markets (March 1, 2012). Annual Review of Financial Economics 4, 339-360, October 2012. Available at SSRN: https://ssrn.com/abstract=1976347 or http://dx.doi.org/10.2139/ssrn.1976347

Philip Bond

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

Box 353200
Seattle, WA 98195-3200
United States

Alex Edmans (Contact Author)

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

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Itay Goldstein

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

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-746-0499 (Phone)

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