Working Paper: NBER ID: w13475
Authors: Georgemarios Angeletos; Guido Lorenzoni; Alessandro Pavan
Abstract: Financial markets look at data on aggregate investment for clues about underlying profitability. At the same time, firms' investment depends on expected equity prices. This generates a two-way feedback between financial market prices and investment. In this paper we study the positive and normative implications of this interaction during episodes of intense technological change, when information about new investment opportunities is highly dispersed. Because high aggregate investment is "good news" for profitability, asset prices increase with aggregate investment. Because firms' incentives to invest in turn increase with asset prices, an endogenous complementarity emerges in investment decisions -- a complementarity that is due purely to informational reasons. We show that this complementarity dampens the impact of fundamentals (shifts in underlying profitability) and amplifies the impact of noise (correlated errors in individual assessments of profitability). We next show that these effects are symptoms of inefficiency: equilibrium investment reacts too little to fundamentals and too much to noise. We finally discuss policies that improve efficiency without requiring any informational advantage on the government's side.
Keywords: Financial Markets; Investment; Information Asymmetry; Technological Change
JEL Codes: E2; G1; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high aggregate investment (E22) | increased asset prices (G19) |
| increased asset prices (G19) | incentivize firms to invest (H32) |
| entrepreneur's expectation of higher aggregate investment (E22) | increased willingness to invest (G31) |
| high aggregate investment (E22) | higher future asset prices (G19) |
| expectational shocks (D84) | amplifies investment decisions (G11) |
| fundamental shocks (E32) | dampens investment decisions (G11) |
| interaction of investment and asset prices (G19) | allocative inefficiency (D61) |
| policies stabilizing asset prices (E63) | mitigate inefficiencies (D61) |