The Macroeconomics of Arbitrage Trading -- Dynamics and Multiple Equilibria with Arbitrage, Production and Collateral Constraints

Abstract

We develop a simple general equilibrium model to study the interactions between limits of arbitrage and aggregate economic activities within a conventional macroeconomic framework. Financially constrained arbitrageurs exploit price anomaly across segmented markets while collateralizing their arbitrage trades with capital investment in the production sector. We derive the model dynamics analytically to illustrate that mispricing arising from insufficient arbitrage activities helps boost the production by raising the marginal return of capital with collateral premium. However, limited arbitrage also renders the economy vulnerable to systemic risks. In addition, we analytically characterize the multiple equilibria to account for the nonlinear aspects of financial crises and the post-crisis recovery through regime shifts.

Keywords: limits of arbitrage, financial intermediary, segmented markets, financial crises, mispricing, regime shift, multiple equilibria, collateral constraints, externality

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