Speculation and Financial Wealth Distribution Under Belief Heterogeneity
Economic Journal Forthcoming
64 Pages Posted: 2 Sep 2015 Last revised: 27 Aug 2017
Date Written: November 1, 2013
Under limited commitment that prevents agents from pledging their future non-financial wealth, agents with incorrect beliefs always survive by holding on to their non-financial wealth. Friedman (1953)’s market selection hypothesis suggests that their financial wealth trends towards zero in the long run. However, in this paper, we present a dynamic general equilibrium model with incomplete markets due to collateral constraints and show that the hypothesis depends on the degree of market incompleteness. When markets are more incomplete, over-optimistic agents not only survive but also prosper by speculation. But they end up with low long run financial wealth when markets are more complete. In this model, stricter margin requirements protect the wealth of the optimists and thereby increase asset price volatility. The numerical method developed in this paper can be used for many other heterogeneous agent models with recursive utility functions, incomplete markets, portfolio constraints, and in the presence of non-tradable endowments.
Keywords: Heterogeneous Beliefs; Market Selection Hypothesis; Incomplete Markets; Collateral Constraint; Speculation; Asset Pricing; Global Nonlinear Methods
JEL Classification: C62, C68, D52, D53, D84, E44, G12
Suggested Citation: Suggested Citation