Working Paper: NBER ID: w28967
Authors: Xavier Gabaix; Ralph S. J. 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. \nUsing 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. \nWe 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. \nOur 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: financial fluctuations; inelastic markets; capital flows; stock market volatility
JEL Codes: E7; G1; G32; G4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor flows (F21) | Stock market valuations (G19) |
| $1 reallocation from bonds to stocks (G11) | Aggregate market valuation (G19) |
| Demand shocks (E39) | Stock market prices (G10) |
| Corporate actions (stock buybacks) (G34) | Market valuations (G19) |
| Investor flows and demand shocks (G19) | Price sensitivity of stock market (G10) |
| Price elasticity of demand for stocks (D12) | Market value (D46) |