In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis

120 Pages Posted: 23 Oct 2020 Last revised: 12 Jun 2021

See all articles by Xavier Gabaix

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Ralph S. J. Koijen

University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: June 11, 2021

Abstract

We develop a framework to theoretically and empirically analyze the fluctuations of the aggregate stock market. Households allocate capital to institutions, which are fairly constrained, for example operating with a mandate to maintain a fixed equity share or with moderate scope for variation in response to changing market conditions. As a result, the price elasticity of demand of the aggregate stock market is small, and flows in and out of the stock market have large impacts on prices.
Using the recent method of granular instrumental variables, we find that investing $1 in the stock market increases the market’s aggregate value by about $5. We also develop a new measure of capital flows into the market, consistent with our theory. We relate it to prices, macroeconomic variables, and survey expectations of returns. We analyze how key parts of macro-finance change if markets are inelastic. We show how general equilibrium models and pricing kernels can be generalized to incorporate flows, which makes them amenable to use in more realistic macroeconomic models and to policy analysis. Our framework allows us to give a dynamic economic structure to old and recent datasets comprising holdings and flows in various segments of the market. The mystery of apparently random movements of the stock market, hard to link to fundamentals, is replaced by the more manageable problem of understanding the determinants of flows in inelastic markets. We delineate a research agenda that can explore a number of questions raised by this analysis, and might lead to a more concrete understanding of the origins of financial fluctuations across markets.

Suggested Citation

Gabaix, Xavier and Koijen, Ralph S. J., In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis (June 11, 2021). Swiss Finance Institute Research Paper No. 20-91, Available at SSRN: https://ssrn.com/abstract=3686935 or http://dx.doi.org/10.2139/ssrn.3686935

Xavier Gabaix

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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European Corporate Governance Institute (ECGI)

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Ralph S. J. Koijen (Contact Author)

University of Chicago - Booth School of Business ( email )

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HOME PAGE: http://faculty.chicagobooth.edu/ralph.koijen/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

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United States

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