Belief Heterogeneity, Collateral Constraint, and Asset Prices with a Quantitative Assessment∗

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 the wealth distribution also generates various patterns of booms and busts in asset prices observed in Burnside, Eichenbaum, and Rebelo (2011). Laslty, I use this framework to study the effects of financial regulation and of the financial wealth distribution on leverage and asset price volatility.