On Trees and Logs

Posted: 8 Oct 2003

See all articles by Anna Pavlova

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

David Cass (deceased)

University of Pennsylvania, School of Arts & Sciences, Department of Economics (deceased)

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Abstract

In this paper we contrast the main workhorse model in asset pricing theory, the Lucas (1978) tree model (LT-Model), to a benchmark model in financial equilibrium theory, the real assets model (RA-Model). It is commonly believed that the two models entail similar conclusions since the LT-Model is a special case of the RA-Model. But this is simply wrong: implications of these models can be strikingly at odds. Indeed, under the widely used log-linear specification of households' preferences, we show that for a large set of initial endowments the LT-Model - even with potentially complete financial markets - admits only peculiar financial equilibria in which the stock market is completely degenerate, in that all stocks offer the same investment opportunity - and yet, allocation is Pareto optimal. We investigate why the LT-Model is so much at variance with the RA-Model, and uncover new results on uniqueness of equilibria and portfolio constraints obtaining in the LT-Model, but not in the RA-Model.

Keywords: Lucas tree model, equilibrium theory, peculiar financial equilibrium, nonuniqueness of equilibria, portfolio constraints

Keywords: Lucas tree model, Equilibrium theory, Peculiar financial equilibrium, Nonuniqueness of equilibria, Portfolio constraints

JEL Classification: D50, G00, G12

Suggested Citation

Pavlova, Anna and Cass (deceased), David, On Trees and Logs. Available at SSRN: https://ssrn.com/abstract=452520

Anna Pavlova (Contact Author)

London Business School ( email )

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HOME PAGE: http://https://www.anna-pavlova.co.uk/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

David Cass (deceased)

University of Pennsylvania, School of Arts & Sciences, Department of Economics (deceased)

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