Speculation and Financial Wealth Distribution under Belief Heterogeneity∗

Under limited commitment that prevents agents from pledging their future nonfinancial wealth, agents with incorrect beliefs always survive by holding on their nonfinancial wealth. Friedman (1953)’s market selection hypothesis suggests that their financial wealth trends towards zero in the long run. However, in this paper, I construct an example in dynamic general equilibrium in which over-optimistic agents not only survive but also prosper by holding an increasingly larger share of a real asset and driving up the price of the asset: they prosper by speculation. The endogenous price dynamics implied by different beliefs is an essential ingredient to the mechanism. ∗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, Ricardo Caballero and the MIT Macro seminar, Macro Lunch, Theory Lunch, International breakfast participants for helpful comments and discussions. I also thank Markus Brunnermeier, Jinhui Bai, Tim Cogley, Behzad Diba, John Geanakoplos, Mark Huggett, Felix Kubler, Dirk Krueger, Per Krusell, Viktor Tsyrennikov, 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, NYU-Columbia NBER mathematical economics meeting for comments and discussions on the later versions of the paper. †Email: [email protected]