The Macroeconomic Implications of Limited Arbitrage

Abstract

We develop a tractable model to study the macroeconomic impacts of limited arbitrage through collateralization. Arbitrage activities and the business cycle are mutually enhancing; but their interaction can escalate unexpected shocks into arbitrage crashes and recession. Through the interaction, we derive a micro-foundation for the endogenous, time-varying, negative borrowing rates and identify the relevant policy transmission channel. With regime shifts, we account for the non-linear aspects of crises and the slow and 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