The Macroeconomic Implications of Limited Arbitrage

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