The Macroeconomic Implications of Limited Arbitrage

38 Pages Posted: 17 Jan 2017 Last revised: 22 Mar 2021

See all articles by Ally Zhang

Ally Zhang

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

Date Written: March 22, 2021

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

Suggested Citation

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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