Theoretical Economics 16 (2021), 275–315
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Macro-financial volatility under dispersed information
Jianjun Miao, Jieran Wu, Eric R. Young
Abstract
We provide a production-based asset pricing model with dispersed
information and small deviations from full rational expectations. In the
model, aggregate output and equity prices depend on the higher-order beliefs
about aggregate demand and individual stochastic discount factors. We prove
that equity price volatility becomes arbitrarily large as the volatility of
idiosyncratic shocks diverges to infinity due to the interaction of
signal-extraction with idiosyncratic trading decisions, while aggregate
output volatility falls. We propose a two-step spectral factorization method
that permits closed-form solutions in the frequency domain applicable to a
wide range of models with more hidden states than signals. Our model can
quantitatively match output and equity volatilities observed in US data.
Keywords: Dispersed information, frequency domain analysis, higher-order beliefs, asset pricing, business cycles, incomplete markets
JEL classification: E32, E44, G12, G14
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