Inefficient Capital Markets and the Macroeconomy

The Efficient Market Hypothesis (EMH) has impacted profoundly academic research, financial regulation and market practice. For example, (i) many macroeconomic models incorporate implications of EMH such as the Expectations Hypothesis and the Uncovered Interest Parity, (ii) regulators evaluate the solvency of many types of financial institutions based on the market value of their assets, and (iii) large pools of money track passively market indices, while active managers are evaluated based on such indices and are often constrained in their deviations from them. A large empirical literature documents, however, that asset prices deviate substantially from their EMH-implied fundamental values. Mispricing and its implications can be usefully studied within the "Limits of Arbitrage" (LoA) paradigm, which posits that agents differ in their expertise to access financial markets, and contracting frictions limit the capital of non-experts that experts can manage. The proposed research will strengthen the LoA paradigm and use it to determine how implications for EMH for asset management, financial regulation and macroeconomics should be modified in inefficient markets. We will put the LoA paradigm on firm foundations by deriving the constraints faced by experts based on endogenous contracting frictions. This will also allow us to determine whether privately optimal contracts render investment horizons sufficiently long and markets sufficiently stable. We will explore three areas of application. One is to derive a taxonomy of investment strategies in inefficient markets and determine how optimal strategies differ across long- and short-horizon investors. Another is to characterize how mispricing affects real investment, and whether short horizons by arbitrageurs spill over to those of corporate managers. A third is to embed the model into a New Keynesian open-economy setting and examine how LoA in bond and currency markets affect the transmission of shocks and policy actions.