Working Paper: CEPR ID: DP10007
Authors: Tarek Hassan; Thomas M. Mertens
Abstract: We show that the stock market may fail to aggregate information even if it appears to be efficient and that the resulting decrease in the information content of stock prices may drastically reduce welfare. We solve a macroeconomic model in which information about fundamentals is dispersed and households make small, correlated errors when forming expectations about future productivity. As information aggregates in the market, these errors amplify and crowd out the information content of stock prices. When stock prices reflect less information, the conditional variance of stock returns rises. This increase in financial risk distorts the long-run levelof capital accumulation, and causes costly (first-order) distortions in the long-run level of consumption.
Keywords: dispersed information; information aggregation; information externality; stock market dysfunctionality
JEL Codes: D83; E2; E3; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Stock market's failure to aggregate information (D89) | Decrease in welfare (I38) |
| Households making small correlated errors in expectations about future productivity (D19) | Higher conditional variance of stock returns (G17) |
| Higher conditional variance of stock returns (G17) | Distortion of capital accumulation and consumption levels (E21) |
| Breakdown of information aggregation (D83) | Higher financial risk (G19) |
| Higher financial risk (G19) | Socially costly distortions in economic aggregates (H31) |
| Near-rational behavior (D01) | Decrease in expected capital accumulation (E22) |
| Near-rational behavior (D01) | Increase in variance of portfolio returns (G11) |
| Near-rational behavior (D01) | Aggregate welfare losses (D69) |