The Macroeconomic Implications of Limited Arbitrage

Abstract

We develop a model to incorporate securitization into speculations and study the transmission channel between arbitrage crashes and recessions in the real economy. We show that the interaction between limited arbitrage and the business cycle works as a powerful transmission mechanism, where trivial shocks can spread, amplify and trigger simultaneous arbitrage failure and recessions. The securitization allows real-sector investments to have extra collateral value and thus helps boost the aggregate production. We solve the closed-form model and characterize multiple equilibria. Through regime shifts, we account for the nonlinearity of financial crises as well as the slow and limited post-crisis recovery.

Keywords: limits of arbitrage, financial crises, mispricing, regime shifts, multiple equilibria, collateral constraints, externality, slow recovery

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