The Impact of Short-Selling Constraints on Financial Market Stability in a Model with Heterogeneous Agents

Publisher:
Elsevier Inc
Publication Type:
Journal Article
Citation:
Journal of Economic Dynamics and Control, 2013, 37 (8), pp. 1523 - 1543
Issue Date:
2013-01
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Recent turmoil on global financial markets has led to a discussion on which policy measures should or could be taken to stabilize financial markets. One such a measure that resurfaced is the imposition of short-selling constraints. It is conjectured that these short-selling constraints reduce speculative trading and thereby have the potential to stabilize volatile financial markets. The purpose of the current paper is to investigate this conjecture in a standard asset pricing model with heterogeneous beliefs. We model short-selling constraints by imposing trading costs for selling an asset short. We find that the local stability properties of the fundamental rational expectations equilibrium do not change when trading costs for short-selling are introduced. However, when the asset is overvalued, costs for short-selling increase mispricing and price volatility.
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