DP10007 The Social Cost of Near-Rational Investment

Author(s): Tarek Alexander Hassan, Thomas M. Mertens
Publication Date: June 2014
Keyword(s): dispersed information, information aggregation, information externality, stock market dysfunctionality
JEL(s): D83, E2, E3, G1
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10007

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 stock 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 stock prices reflect less information, the conditional variance of stock returns rises. This increase in financial risk distorts the long-run level of capital accumulation, and causes costly (first-order) distortions in the long-run level of consumption.