Discussion Paper Details

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Title: The Macroeconomics of Financial Speculation

Author(s): Alp Simsek

Publication Date: January 2021

Keyword(s): aggregate demand recessions, belief disagreements, business cycles, countercyclical risk premium, financial speculation, leverage, macroprudential policy, Rational bubbles, Short selling and Speculative bubbles

Programme Area(s): Financial Economics, International Macroeconomics and Finance and Monetary Economics and Fluctuations

Abstract: I review the literature on financial speculation driven by belief disagreements from a macroeconomics perspective. To highlight unifying themes, I develop a stylized macroeconomic model that embeds several mechanisms. With short-selling constraints, speculation can generate overvaluation and speculative bubbles. Leverage can substantially inflate speculative bubbles and leverage limits depend on perceived downside risks. Shifts in beliefs about downside tail scenarios can explain the emergence and the collapse of leveraged speculative bubbles. Speculative bubbles are related to rational bubbles, but they match better the empirical evidence on the predictability of asset returns. Even without short-selling constraints, speculation induces procyclical asset valuation. When speculation affects the price of aggregate assets, it also influences macroeconomic outcomes such as aggregate consumption, investment, and output. Speculation in the boom years reduces asset prices, aggregate demand, and output in the subsequent recession. Macroprudential policies that restrict speculation in the boom can improve macroeconomic stability and social welfare.

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Bibliographic Reference

Simsek, A. 2021. 'The Macroeconomics of Financial Speculation'. London, Centre for Economic Policy Research.