The financial crisis of 2007-2009 highlighted the importance of financial market frictions
in the real-economy. There is a burgeoning literature that looks to the role of assets
as collateral in over-the-counter transactions as a possible source of instability.
However, most models incorporate rational expectations and, as such, have difficulty
in generating empirically plausible asset price features such as excess volatility,
bubbles and crashes. This talk will discuss the implications of introducing bounded
rationality into search models that include a liquidity role for assets. Branch will
begin by incorporating traders with heterogeneous beliefs who trade an asset in bilateral
meetings. In this setting, there are four primary results. First, heterogeneous beliefs
can, in general, lead to trading inefficiencies that would not arise under homogeneous
beliefs. Second, heterogeneous beliefs can destabilize a stationary equilibrium and
lead to periodic and complex dynamics that remain bounded around the steady state.
Third, along these dynamic paths, there is a non-degenerate, time-varying wealth distribution.
Fourth, dynamic equilibria can feature a time-varying extensive margin of trade. The
unique theoretical predictions from heterogeneous beliefs provide a potential explanation
of experimental findings reported in Duffy and Puzzello. Finally, a stock-pricing
example will be presented that provides quantitative evidence on the importance of
the liquidity channel for generating bubbles and crashes.
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