Speculation and Financial Wealth Distribution Under Belief Heterogeneity

Abstract

Under limited commitment that prevents agents from pledging their future non-financial wealth, agents with incorrect beliefs always survive by holding on to their non-financial wealth. Friedman's () market selection hypothesis suggests that their financial wealth trends towards zero in the long run. However, I present a dynamic general equilibrium model with incomplete markets due to collateral constraints and show that the hypothesis depends on the degree of market incompleteness. When markets are more incomplete, over-optimistic agents not only survive but also prosper by speculation. Stricter margin requirements protect the wealth of the optimists and thereby increase asset price volatility.