Does Speculation in Financial Markets Have Real Effects?
63 Pages Posted: 19 Jun 2019 Last revised: 2 Aug 2021
Date Written: June 12, 2019
Investors with recursive preferences disagree on real productivity and extraneous
risks in a production economy with non-smooth adjustment costs. Speculation in financial
markets, especially on extraneous risks, can be long-lasting and significantly
impact the real economy. It can either decrease or increase real investment and asset
prices depending on whether investors’ EIS is less or greater than 1. It may make
the economy switch between production and pure exchange, and speculation with
extraneous risk always increases asset volatility in the pure-exchange phase. Any
idiosyncratic extraneous risk becomes systematic if investors disagree on it and trade
it in financial markets. With the EIS greater than 1, speculation can generate various
boom-and-bust patterns observed in the recent US housing markets.
Keywords: Speculation, Heterogeneous Beliefs, Investment, Extraneous Risk, EIS, Survivability, Housing Booms and Busts
JEL Classification: E32, G12, G18
Suggested Citation: Suggested Citation