Monday, July 13, 2015

Macro-finacial economics puzzles: 3 out of 10 ain't bad

Noah Smith linked to this paper by Xavier Gabaix [pdf] again the other day which reminded me that I had a draft post I was working on before taking a short break from blogging. For those suffering from information transfer economics withdrawal (all zero of you), here it is ...

Noah Smith linked to this paper by Xavier Gabaix [pdf] that succinctly described 10 "puzzles" of financial economics (and how they could be solved by considering the risk of rare disasters). I'd like to point out that the information transfer model has its own solution to a few of them (not entirely unrelated as 'rare disasters' could be called 'rare non-ideal information transfer'):
3. Excess volatility puzzle: Stock prices seem more volatile than warranted by a model with a constant discount rate (Shiller 1981).
Any kind of excess volatility (exchange rates) could result from the combination of non-ideal information transfer and investors having the wrong model for pricing an asset as I discuss here.
4. Aggregate return predictability: Future aggregate stock market returns are partly predicted by price/dividend (P/D) and similar ratios (Campbell and Shiller 1998).
The aggregate stock market can be considered to be made up of many individual stocks with a distribution of different (and changing) information transfer indices (hence different returns from period to period). This distribution (given a large number of companies) is roughly constant and the prices are based on fundamentals (hence things like book value or P/D ratios) with random fluctuations. Effectively this is applying the partition function approach to this model of individual stocks.

Another way to put this is that in the same way the aggregate economy (roughly) follows the quantity theory of money even though it's made up of many sectors each doing very badly, very well or just kind of muddling through, stocks have aggregate predictable returns even though individual companies come and go.
6. Yield curve slope puzzle: The nominal yield curve slopes up on average. The premium of long-term yields over short term yields is too high to be explained by a traditional RBC model. This is the bond version of the equity premium puzzle (Campbell 2003).
In the information transfer model, the difference between long term and short term interest rates (on average) is mostly due to central bank reserves. No reserves and the premium would be smaller. There is a secondary effect where short term rates are given to more serious bouts of non-ideal information transfer, hence tend to fall below their "information equilibrium" value more often than long term rates.


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