The Social Cost of Near-Rational Investment

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...

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Bibliographic Details
Published in:The American economic review 2017-04, Vol.107 (4), p.1059-1103
Main Authors: Hassan, Tarek A., Mertens, Thomas M.
Format: Article
Language:English
Subjects:
Accumulation
Capital formation
Consumption
Economic expectations
Economic Models
Efficient markets
Household consumption
Households
Industrial productivity
Information content
Information retrieval noise
Labor supply
Prices
Productivity
Rational expectations
Securities markets
Signal noise
Social Costs
Standard deviation
Stock Prices
Uncertainty
Welfare
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Summary: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.
ISSN:0002-8282
1944-7981
DOI:10.1257/aer.20110433