Myopia, Time-Inconsistency and Financial Markets

What is the characterization of asset prices and investor’s behavior under time-inconsistent preferences? This paper investigates the characterization of financial market equilibrium when time-inconsistency takes the form of myopia or hyperbolic discounting (HD). We consider an infinite horizon economy under certainty with two heterogeneous CRRA individuals, one good and one long-lived asset. The question of survival in the market arises when individuals are HD maximizers or myopic with wrong expectations about equilibrium asset prices. We provide sufficient conditions such that more myopic individuals dominate over less myopic ones and also sophisticated HD maximizers with intertemporal elasticity of substitution (IES) equal to one, log-utilities, dominate over HD maximizers with IES higher than one. Thus, individuals that vanish in the long-run will not have an impact on asset prices. On the other hand, asset prices are characterized by extreme dynamics if the economy is populated by myopic individuals only, who have perfect foresight about equilibrium asset prices. We show that even though the dividends of the long-lived asset are constant over time, there exist asset price dynamics that resemble an ever-expanding asset price bubble. Lastly, we introduce debt in the initial set-up by allowing individuals to hold liquid and illiquid assets. This allows for the possibility of bankruptcies.