Market Turmoil and Destabilizing Speculation

Abstract

This paper explores how speculators can destabilize financial markets by amplifying negative shocks. During periods of turmoil created by an uncertainty shock, speculators react to declining asset prices by liquidating their holdings in hopes of buying them back later at a gain, despite the asset's cash flows remaining the same throughout and the absence of financial constraints. A reduction in search frictions tends to exacerbate fluctuations in asset prices. At the root of these results are the strategic complementarities between speculators expected to follow similar strategies in the future. The model sheds new lights on recent financial events and provides testable empirical implications.