The Macroeconomic Implications of Limited Arbitrage

Abstract

We develop a model to study the macroeconomic impacts of limited arbitrage through collateralization. From the interactions between arbitrage trading and the business cycle, we identify an endogenous, time-varying, negative borrowing rate among financial institutions. We show that this rate helps boost capital formation and growth, but also underlies a more powerful shock transmission channel than the conventional credit cycle, contributing to simultaneous arbitrage failure and recession. With regime shifts, we account for the non-linear aspects of crises and the slow, incomplete recoveries. Given the post-crisis regulatory reforms, we derive policy implications on liquidity provision, financial resilience and economic growth.

Keywords: limits of arbitrage, financial crises, mispricing, slow recovery, regime shifts, multiple equilibria, collateralization, externality

JEL Classification: D52, D58, E44, G01, G12