Wall Street and Silicon Valley
Subtitle: a delicate interaction
By: George-Marios Angeletos, Guido Lorenzoni, Alessandro Pavan
Contributors: Lorenzoni, Guido; Pavan, Alessandro; Massachusetts Institute of Technology. Dept. of Economics
Series: Working paper series / Massachusetts Institute of Technology, Dept. of Economics -- working paper 07-25; Working paper (Massachusetts Institute of Technology. Dept. of Economics) -- no. 07-25.
Publisher: Massachusetts Institute of Technology, Dept. of Economics
Published: 2007
Place of publication: Cambridge, MA
Language: eng
Number of pages: 49
Subjects: Econometric models; Technological innovations; Economic aspects; Saving and investment
Description: Financial markets look at data on aggregate investment for clues about underlying profitability. At the same time, firms' investment depends on expected equity prices. This generates a two-way feedback between financial market prices and investment. In this paper we study the positive and normative implications of this interaction during episodes of intense technological change, when information about new investment opportunities is highly dispersed. Because high aggregate investment is "good news" for profitability, asset prices increase with aggregate investment. Because firms' incentives to invest in turn increase with asset prices, an endogenous complementarity emerges in investment decisions - a complementarity that is due purely to informational reasons. We show that this complementarity dampens the impact of fundamentals (shifts in underlying profitability) and amplifies the impact of noise (correlated errors in individual assessments of profitability). We next show that these effects are symptoms of inefficiency: equilibrium investment reacts too little to fundamentals and too much to noise. We finally discuss policies that improve efficiency without requiring any informational advantage on the government's side. Keywords: heterogeneous information, complementarity, volatility, inefficiency, beauty contests.
Notes: "September 23, 2007."

Includes bibliographic reference (p. 46-49).

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