Working Paper: CEPR ID: DP16290
Authors: Xavier Gabaix; Ralph Koijen
Abstract: We develop a framework to theoretically and empirically analyze the fluctuations of the aggregate stock market. Households allocate capital to institutions, which are fairly constrained, for example operating with a mandate to maintain a fixed equity share or with moderate scope for variation in response to changing market conditions. As a result, the price elasticity of demand of the aggregate stock market is small, and flows in and out of the stock market have large impacts on prices.Using the recent method of granular instrumental variables, we find that investing $1 in the stock market increases the market’s aggregate value by about $5. We also develop a new measure of capital flows into the market, consistent with our theory. We relate it to prices, macroeconomic variables, and survey expectations of returns.We analyze how key parts of macro-finance change if markets are inelastic. We show how general equilibrium models and pricing kernels can be generalized to incorporate flows, which makes them amenable to use in more realistic macroeconomic models and to policy analysis.Our framework allows us to give a dynamic economic structure to old and recent datasets comprising holdings and flows in various segments of the market. The mystery of apparently random movements of the stock market, hard to link to fundamentals, is replaced by the more manageable problem of understanding the determinants of flows in inelastic markets. We delineate a research agenda that can explore a number of questions raised by this analysis, and might lead to a more concrete understanding of the origins of financial fluctuations across markets.
Keywords: asset market fluctuations; flows; excess volatility; behavioral finance; behavioral macroeconomics
JEL Codes: E7; G1; G4; G10; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Capital flows (F32) | Stock market valuations (G19) |
| Demand shocks (E39) | Stock market valuations (G19) |
| Capital flows (F32) | Price changes (P22) |
| Price changes (P22) | Demand for stocks (J23) |
| Capital flows (F32) | Expected returns (G17) |
| Government interventions (E65) | Stock prices (G19) |