Working Paper: NBER ID: w17027
Authors: Tarek A. 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 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 prices reflect less information, the conditional variance of stock returns rises, causing an increase in uncertainty and costly distortions in consumption, capital accumulation, and labor supply.
Keywords: Near-rational behavior; Information aggregation; Social cost; Welfare; Stock market efficiency
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 |
|---|---|
| Dispersion of private information (D82) | Stock market's capacity to aggregate information (D83) |
| Small correlated errors in expectations (C51) | Amplified non-fundamental deviations in stock prices (G19) |
| Amplified non-fundamental deviations in stock prices (G19) | Distortion of household expectations (H31) |
| Distortion of household expectations (H31) | Misinformed investment decisions (G11) |
| Near-rational behavior (D01) | Social cost of welfare loss (D69) |
| Distortion in capital accumulation (E22) | Reduction in overall output (E23) |