Firm Disclosure, Financial Markets and the Macroeconomy

Abstract

How does the financial sector affect the aggregate economy? This paper proposes a novel informational amplification and spillover channel. Our model demonstrates mutual learning between firms and financial markets: a firm's information disclosure can attract more information from the financial market, which can guide the manager to make a better investment decision. In a Lucas islands economy setting, we show that information production complementarities exist between the financial sector and the real sector within an island and between islands. When the financial sector in some islands suffers a negative shock, it becomes less able to conduct price discovery. This leads to the real sector in these islands having less incentives to produce information. Noisier information signals result in less-efficient real investment decisions in these islands and hence lower aggregate output. Facing the decline in aggregate demand, other islands are affected, with less information acquisitions and lower output. The negative impact on this part of the economy feeds back to the original part of the economy. In general equilibrium, aggregate real output (i.e., the level of economic activity) and financial market efficiency (i.e., the level of information) feed back and reinforce each other, leading to excess volatility on both sides. The welfare implications of the model are analyzed.