Working Paper: CEPR ID: DP15733
Authors: Alp Simsek
Abstract: I review the literature on financial speculation driven by belief disagreements from a macroeconomics perspective. To highlight unifying themes, I develop a stylized macroeconomic model that embeds several mechanisms. With short-selling constraints, speculation can generate overvaluation and speculative bubbles. Leverage can substantially inflate speculative bubbles and leverage limits depend on perceived downside risks. Shifts in beliefs about downside tail scenarios can explain the emergence and the collapse of leveraged speculative bubbles. Speculative bubbles are related to rational bubbles, but they match better the empirical evidence on the predictability of asset returns. Even without short-selling constraints, speculation induces procyclical asset valuation. When speculation affects the price of aggregate assets, it also influences macroeconomic outcomes such as aggregate consumption, investment, and output. Speculation in the boom years reduces asset prices, aggregate demand, and output in the subsequent recession. Macroprudential policies that restrict speculation in the boom can improve macroeconomic stability and social welfare.
Keywords: Financial speculation; Belief disagreements; Short selling; Leverage; Speculative bubbles; Rational bubbles; Countercyclical risk premium; Business cycles; Aggregate demand; Recessions; Macroprudential policy
JEL Codes: E00; E12; E21; E22; E32; E44; E52; E70; G00; G01; G11; G12; G40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Speculation (D84) | Overvaluation (F31) |
| Overvaluation (F31) | Asset Prices (G19) |
| Speculation (D84) | Speculative Bubbles (E32) |
| Leverage (G32) | Overvaluation (F31) |
| Leverage (G32) | Speculative Bubbles (E32) |
| Shifts in Beliefs about Downside Risks (D81) | Leverage Limits (G32) |
| Shifts in Beliefs about Tail Scenarios (D81) | Emergence of Speculative Bubbles (E32) |
| Speculation (D84) | Procyclical Asset Valuation (G19) |
| Procyclical Asset Valuation (G19) | Macroeconomic Outcomes (E19) |
| Speculation (D84) | Aggregate Demand Contractions During Recessions (E00) |
| Speculation in Boom Years (E32) | Lower Asset Prices and Output in Subsequent Downturns (E44) |