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In this paper, we study the effect of proportional transaction costs on consumption-portfolio decisions and asset prices in a dynamic general equilibrium economy with a financial market that has a single-period bond and two risky stocks, one of which incurs the transaction cost. Our model has multiple investors with stochastic labor income, heterogeneous beliefs, and heterogeneous Epstein-Zin-Weil utility functions. The transaction cost gives rise to endogenous variations in liquidity. We show how equilibrium in this incomplete-markets economy can be characterized and solved for in a recursive fashion. We have three main findings. One, costs for trading a stock lead to a substantial reduction in the trading volume of that stock, but have only a small effect on the trading volume of the other stock and the bond. Two, even in the presence of stochastic labor income and heterogeneous beliefs, transaction costs have only a small effect on the consumption decisions of investors, and hence, on equity risk premia and the liquidity premium. Three, the effects of transaction costs on quantities such as the liquidity premium are overestimated in partial equilibrium relative to general equilibrium.
We propose a 2-country asset-pricing model where agents' preferences change endogenously as a function of the popularity of internationally traded goods. We determine the effect of the time-variation of preferences on equity markets, consumption and portfolio choices. When agents are more sensitive to the popularity of domestic consumption goods, the local stock market reacts more strongly to the preferences of local agents than to the preferences of foreign agents. Therefore, home bias arises because home-country stock represents a better investment opportunity for hedging against future fluctuations in preferences. We test our model and find that preference evolution is a plausible driver of key macroeconomic variables and stock returns.
Can boundedly rational agents survive competition with fully rational agents? The authors develop a highly nonlinear heterogeneous agents model with rational forward looking versus boundedly rational backward looking agents and evolving market shares depending on their relative performance. Their novel numerical solution method detects equilibrium paths characterized by complex bubble and crash dynamics. Boundedly rational trend-extrapolators amplify small deviations from fundamentals, while rational agents anticipate market crashes after large bubbles and drive prices back close to fundamental value. Overall rational and non-rational beliefs co-evolve over time, with time-varying impact, and their interaction produces complex endogenous bubble and crashes, without any exogenous shocks.