The Real Effects of Stock Market Mispricing at the Aggregate: Theory and Empirical Evidence

55 Pages Posted: 9 May 2005  

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Stavros Panageas

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Date Written: December 2004

Abstract

In this paper we investigate whether stock market overpricing leads to aggregate (real) inefficiencies. We first investigate a standard dynamic contracting model of investment subject to financing constraints. We show that stock market mispricing will have two robust effects on welfare: on the one hand it will distort investment decisions and lead to inefficiencies. On the other hand it will alleviate underinvestment problems and allow some efficient projects to be undertaken. We then turn to the data and investigate which of the two effects dominates at the aggregate. By using proxies for investor sentiment within a vector autoregression (VAR) we find that positive shocks to sentiment boost (real) investment while reducing aggregate profits over the long run, all else equal. We interpret this as evidence that mispricing causes more inefficiencies than it corrects.

Keywords: Mispricing, Efficiency, Real Effects of Stock market bubbles, Investment, Investor Sentiment

JEL Classification: G0, E2

Suggested Citation

Farhi, Emmanuel and Panageas, Stavros, The Real Effects of Stock Market Mispricing at the Aggregate: Theory and Empirical Evidence (December 2004). Available at SSRN: https://ssrn.com/abstract=720462 or http://dx.doi.org/10.2139/ssrn.720462

Emmanuel Farhi

Harvard University - Department of Economics ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Stavros Panageas (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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