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Many identify inflated credit ratings as one contributor to the recent financial market turmoil. We develop an equilibrium model of the market for ratings and use it to examine possible origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings – observe multiple ratings and disclose only the most favorable – before auctioning their assets. When assets are simple, agencies’ ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings, despite the fact that each ratings agency produces an unbiased estimate of the asset’s true quality. Increasing competition among agencies would only worsen this problem. Switching to an investor-initiated ratings system alleviates the bias, but could collapse the market for information.

We study the effect of releasing public information about productivity or monetary shocks (for example, as a consequence of publishing an economic aggregate) using a micro-founded macroeconomic model where agents learn from the distribution of nominal prices. While a public release has the direct beneficial effect of providing new information, it can also have the indirect adverse effect of reducing the informational efficiency of the price system. We show that the negative indirect effect can dominate: thus, the public information release will increase uncertainty about the monetary shock and reduce welfare. We find that the optimal communication policy is always to release either all or none of the information. Our results are robust to considering a “cashless limit ” for our economy and to introducing complementarities in production. We’d like to thank, for fruitful discussions and suggestions, George-Marios Angeletos, Andy Atkeson,

Abstract: The paper examines time series properties and efficiency of a securities market where disparately informed traders hold rational expectations and extract signals from the endogenous market price. Two equilibria are calculated, using a method of Sargent to handle the problem of infinite regress. When rational speculation is the sole source of potential trade, the market price reflects all private information, and zero trade occurs. When net supply is perturbed by unobserved noise, the market exhibits a broad range of characteristics cited in empirical literature, including excess volatility, mean reversion, dividend yield effects, trading volume and divergence of opinion. I am indebted to Thomas J. Sargent for helpful discussions. Are securities prices too volatile? This question is central to evaluating how efficiently resources are allocated in a competitive market. A large body of literature suggests that securities markets will generate prices which reflect all available information, even if some traders are better informed than others. Recent empirical studies place this market efficiency

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This paper incorporates excess volatility in stock prices into a standard general equilibrium model and finds large welfare gains from stabilizing policies. Stock prices in this model aggregate information about fundamentals which is dispersed in the economy but also reflect excess volatility stemming from correlated distortions in beliefs. To solve the model, this paper develops a novel solution method for nonlinear models with dispersed information which can be applied to a large class of dynamic general equilibrium models. The innovation lies in a nonlinear change of variables which, when combined with perturbation methods, yields the nonlinear price function consistent with equilibrium expectation operators. The main positive result shows that dispersion of information allows arbitrarily small distortions in beliefs to generate large amounts of excess volatility and renders arbitrage infeasible. The government cannot observe whether a given stock price movement originates from information or noise. As a normative result, price stabilizing policies lead to a higher level of consumption: a fall in the risk premium lowers the marginal product of capital and raises the capital stock and production. History-dependent policies may improve the information content of prices and result in even higher welfare gains.

We argue that many firms become publicly traded on a stock exchange as the first stage of a longer term divestment plan. Making a direct sale of unlisted stock may be associated with great adverse selection costs. The publicly listed stock price reduces adverse selection by aggregating the information of several investors, and this market valuation, rather than the cash infusion, could be the main benefit of an initial public offering. This theory provides a unified treatment of a whole range of empirical observations, in particular why initial owners frequently exit completely subsequent to an initial public offering (IPO) and why the number of stock market introductions increases with the stock price level. The model also reformulates the “sweet taste ” explanation of IPO underpricing in a way which is consistent with recent evidence. Finally, we argue that the number of firms which go public is inefficiently large.

- preliminary draft-This paper proposes a generalized rational expectations model which accommodates social interaction in the financial market economy. Each agent infers information by observing her neighbor’s portfolio. The neighborhood of an agent is determined by her location and connections in a given directed graph, which represents the social network. This modelling of the economy provides a new endogenous information source for the agents on top of the price system. We define a notion of equilibrium for this generalized framework, and study its properties. Our results show that the pattern of social interaction in the economy can significantly affect security pricing. I am very grateful to Andy McLennan and Jan Werner for their valuable advice and unwavering support. I also thank

The arrival of new, unfamiliar, investment opportunities is often associated with “exuberant” movements in asset prices and real economic activity. During these episodes of high uncertainty, financial markets look at the real sector for signals about the profitability of the new investment opportunities, and vice versa. In this paper, we study how such information spillovers impact the incentives that agents face when making their real economic decisions. On the positive front, we find that the sensitivity of equilibrium outcomes to noise and to higher-order uncertainty is amplified, exacerbating the disconnect from fundamentals. On the normative front, we find that these effects are symptoms of constrained inefficiency; we then identify policies that can improve welfare without requiring the government to have any informational advantage vis-a-vis the market. At the heart of these results is a distortion that induces a conventional neoclassical economy to behave as a Keynesian “beauty contest” and to exhibit fluctuations that may look like “irrational exuberance” to an outside observer.