Privileged Information Exacerbates Market Volatility

We study how asymmetric information a¤ects market volatility in a linear setup where the outcome is determined by forecasts about this same outcome. The unique rational expectations equilibrium will be stable when it is the only rationalizable solution. The literature has established that stability is obtained when the sensitivity of the outcome to agents’ forecasts is less than 1, provided that this sensitivity is common knowledge. Relaxing this common knowledge assumption, instability is obtained when the proportion of agents informed of the sensitivity is large, and the uninformed agents believe it is possible that the sensitivity is greater than 1. Keywords: Asymmetric information, common knowledge, eductive learning, rational expectations, rationalizability, volatility. JEL classi…cation: C62, D82, D84. We have bene…ted from the comments of Jess Benhabib, Christophe Chamley, George Evans, Roger Guesnerie, Guy Laroque, Seppo Honkapohja, Stephen Morris, Marion Oury and Olivier Tercieux. The usual disclaimers apply. yCorresponding author: Stéphane Gauthier, CREST-ENSAE, 3 avenue Pierre Larousse, 92245 Malako¤ cedex, France; Phone number: +33141176535; Fax number: +33141173852 ; E-mail address: [email protected]. zTHEMA, Université Cergy-Pontoise. xCREST-ENSAE.