Belief Heterogeneity, Collateral Constraint, and Asset Prices∗

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 introduces a dynamic general equilibriummodel with aggregate shocks, endogeneously 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 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 the movement in the financial wealth distribution between agents with different beliefs permanently drive up asset price volatility. The movement in wealth distribution between agents with different beliefs also generates complex dynamics of asset prices, such as debt-deflation and fire-sale, and booms, busts, and bubbles. Laslty, tighter financial regulation in this framework surprisingly increases the long run financial wealth of agents with incorrect beliefs as well as asset price volatility. ∗I am grateful to Daron Acemoglu and Ivan Werning for their infinite support and guidance during my time at MIT. I wish to thank Guido Lorenzoni and Robert Townsend for their advice since the beginning of this project, to thank Ricardo Caballero and MIT Macro seminar, Macro Lunch, Theory Lunch, International breakfast participants for helpful comments and discussions. I also thank Markus Brunnermeier, Behzad Diba, John Geanakoplos, Mark Huggett, Felix Kubler, Dirk Krueger, Per Krusell, and other participants at conferences and seminars at UCLA, Georgetown, Princeton, UCL, LSE, University of Wisconsin-Madison, Yale, Cowles Foundation, SED meeting in Montreal, Stanford Institute for Theoretical Economics, NYUColumbia NBER mathematical economics meeting for comments and discussions on the later versions of the paper. †Email: [email protected]