The Social Cost of Near-Rational Investment

73 Pages Posted: 25 Sep 2014

See all articles by Tarek A. Hassan

Tarek A. Hassan

Boston University; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Thomas M. Mertens

Federal Reserve Bank of San Francisco

Multiple version iconThere are 3 versions of this paper

Date Written: June 2014

Abstract

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 when forming expectations about future productivity. 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 conditional variance of stock returns rises. This increase in financial risk distorts the long-run level of capital accumulation, and causes costly (first-order) distortions in the long-run level of consumption.

Keywords: dispersed information, information aggregation, information externality, stock market dysfunctionality

JEL Classification: D83, E2, E3, G1

Suggested Citation

Hassan, Tarek Alexander and Mertens, Thomas M., The Social Cost of Near-Rational Investment (June 2014). CEPR Discussion Paper No. DP10007, Available at SSRN: https://ssrn.com/abstract=2501459

Tarek Alexander Hassan (Contact Author)

Boston University ( email )

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National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
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Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Thomas M. Mertens

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

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