Investment, Welfare and the Informativeness of Financial Markets

Asset prices aggregate information about current and future productivity. More information allows firms to make better investment decisions, potentially increasing social welfare. In this paper, I quantify the social value of the information transmitted by the financial system to firms in a real business cycle framework, in an environment with common productivity shocks and temporary, idiosyncratic shocks which inhibit agents’ learning. As a benchmark, I first study the value of information in the absence of a financial system. The observation of the permanent component of aggregate productivity has a positive and significant impact on welfare, and an important fraction of the gain comes from the fact that information reduces the long-run risk faced by the household. Next, I include the financial sector as a noisy rational expectations asset market: financial traders observe private signals about the permanent component of productivity, the stock price aggregates the dispersed information of traders, and noise traders prevent full revelation. I find that both reducing the size of the noisy trade or decreasing the dispersion of information among financial traders have negligible effects on welfare, because the ability of firms to learn from the stock price does not change with these parameters. Finally, increasing the precision of the overall information aggregated by the financial system has a positive but modest effect on social welfare.