Disagreement, Speculation, and Aggregate Investment

Baker Steven, Hollifield Burton and Osambela Emilio

No 2014-E23, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: When investors disagree, speculation between them alters equilibrium prices in financial markets. Because managers maximize firm value given financial market prices, disagreement alters firms' value-maximizing investment policies. Disagreement therefore impacts aggregate investment, consumption, and output. In an otherwise standard production economy, we demonstrate that static disagreement among investors generates dynamic aggregate investment that is positively correlated with capital shocks, leading to stochastic volatility in aggregate consumption, investment and equity returns. The direction of these effects is consistent with business cycle facts. We document that empirical measures of disagreement predict long run stock returns through their effects on the investment-capital ratio.

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