Collateral Shortages, Asset Price and Investment Volatility with Heterogeneous Beliefs

The recent economic crisis highlights the role of financial markets in allowing economic agents, including prominent banks, to speculate on the future returns of different financial assets, such as mortgage-backed securities. This paper in troduces a dynamic general equilibrium model with aggregate shocks, potentially incomplete markets and heterogeneous agents to investigate this role of financial markets. In addition to their risk aversion and endowments, agents differ in their beliefs about the future exogenous states (aggregate and idiosyncratic) of the economy. This difference in beliefs induces them to take large bets under frictionless complete financial markets, which enable agents to leverage their future wealth. Consequently, as hypothesized by Friedman (1953), under complete markets, agents with incorrect beliefs will eventually be driven out of the markets. In this case, they also have no influence on asset prices and real investment in the long run. In contrast, I show that under incomplete markets generated by collateral constraints, agents with heterogeneous (potentially incorrect) beliefs survive in the long run and their speculative activities permanently drive up asset price volatility and real investment volatility. I also show that collateral constraints are always binding even if the supply of collateral assets endogenously responds to their price. I use this framework to study the effects of different types of regulations and the distribution of endowments on leverage, asset price volatility and investment. Lastly, the analytical tools developed in this framework enable me to prove the existence of the "generalized" recursive equilibrium in Krusell and Smith (1998) with a finite number of agents.