The Macroeconomic Implications of Limited Arbitrage

48 Pages Posted: 17 Jan 2017 Last revised: 5 Jan 2022

See all articles by Ally Zhang

Ally Zhang

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

Date Written: March 22, 2021

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

Suggested Citation

Zhang, Quan and Zhang, Quan, The Macroeconomic Implications of Limited Arbitrage (March 22, 2021). 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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