The Macroeconomic Implications of Limited Arbitrage

45 Pages Posted: 17 Jan 2017 Last revised: 29 Dec 2019

See all articles by Ally Zhang

Ally Zhang

Department of Finance, Lancaster University Management School; Swiss Finance Institute

Date Written: December 26, 2019

Abstract

We develop a tractable model to study the macroeconomic impacts of limited arbitrage by linking arbitrage activities with the macroeconomy through collateralization. We show that the interactions between speculative trading and the business cycle can work as a powerful transmission mechanism, where trivial shocks spread, amplify, and trigger simultaneous arbitrage failures and recessions. Collateralization adds extra value to real-sector investments, and ultimately helps boost aggregate production. We solve for the model dynamics analytically and characterize multiple equilibria. Through regime shifts, we account for the non-linear aspects of financial crises as well as the slow and incomplete post-crisis recoveries.

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

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

Suggested Citation

Zhang, Quan, The Macroeconomic Implications of Limited Arbitrage (December 26, 2019). Swiss Finance Institute Research Paper No. 17-02. Available at SSRN: https://ssrn.com/abstract=2899866 or http://dx.doi.org/10.2139/ssrn.2899866

Quan Zhang (Contact Author)

Department of Finance, Lancaster University Management School ( email )

Economics Department,
LUMS,
Bailrigg Lancaster, LA1 4YX
United Kingdom
+441524592776 (Phone)

HOME PAGE: http://www.allyquanzhang.com/wordpress/

Swiss Finance Institute ( email )

Plattenstrasse 32
Zurich, ZH 8032
Switzerland

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