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Limited Market Participation and Volatility of Asset Prices

Franklin Allen and Douglas Gale
The American Economic Review
Vol. 84, No. 4 (Sep., 1994), pp. 933-955
Stable URL: http://www.jstor.org/stable/2118039
Page Count: 23
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Limited Market Participation and Volatility of Asset Prices
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Abstract

Traditional asset-pricing theories assume complete market participation, despite considerable empirical evidence that most investors participate in a limited number of markets. We show that once the participation decision is endogenized, market properties change dramatically. First, limited market participation can amplify the effect of liquidity trading relative to full participation; under certain circumstances, an arbitrarily small aggregate liquidity shock can cause significant price volatility. Second, there exist multiple equilibria with very different participation regimes and levels of asset-price volatility. Third, under plausible conditions the equilibria can be Pareto-ranked; the Pareto-preferred equilibrium is characterized by greater participation and lower volatility.

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