Does Speculation in Financial Markets Have Real Effects?

63 Pages Posted: 19 Jun 2019 Last revised: 2 Aug 2021

See all articles by Tao Li

Tao Li

City University of Hong Kong (CityU) - Department of Economics & Finance

Mark Loewenstein

University of Maryland - Robert H. Smith School of Business

Date Written: June 12, 2019

Abstract

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

Li, Tao and Loewenstein, Mark, Does Speculation in Financial Markets Have Real Effects? (June 12, 2019). Available at SSRN: https://ssrn.com/abstract=3401409 or http://dx.doi.org/10.2139/ssrn.3401409

Tao Li (Contact Author)

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Mark Loewenstein

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States

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