Speculation and Financial Wealth Distribution Under Belief Heterogeneity

Abstract

Under limited commitment that prevents agents from pledging their future non‐financial wealth, agents with incorrect beliefs always survive by holding on to their non‐financial wealth. Friedman's ([Friedman, M., 1953]) market selection hypothesis suggests that their financial wealth trends towards zero in the long run. However, I present a dynamic general equilibrium model with incomplete markets due to collateral constraints and show that the hypothesis depends on the degree of market incompleteness. When markets are more incomplete, over‐optimistic agents not only survive but also prosper by speculation. Stricter margin requirements protect the wealth of the optimists and thereby increase asset price volatility.