Sunspots and Incomplete Financial Markets: The Leading Example
To even the most casual reader of the daily business pages, it must be fairly obvious that financial markets react (or overreact) to much news which clearly (or, at least, arguably) has little or no direct bearing on ‘fundamentals’. Some prominent, current items: the threats issuing from various Middle Eastern factions; the Fed’s weekly announcement of previous changes in the money supply; the outcome of this fall’s Congressional elections; the great deficit debate. Contrary to one’s instinctive reaction as a trained economist, several recent studies have convincingly demonstrated that such market behavior is not necessarily ‘non-economic’ or ‘irrational’. Prices and returns-and hence market allocation itself-may very well consistently depend on purely expectational phenomena. Moreover, self-fulfilling beliefs about market forces may have significant consequences for individual welfare. In short, ‘sunspots’ may matter, and they may matter very much.1
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