Stock Market Volatility in a Heterogeneous Information Economy

Abstract

The informational role of prices contributes positively to their variability. In a noisy rational expectations equilibrium, traders rationally respond to price changes by revising their estimates of other traders' private signals and hence their own expectations of future dividends. The resultant shifts in traders' demands amplify any supply shock-induced price changes. We develop an infinite horizon noisy rational expectations model and calibrate, simulate, and test it using U.S. stock market data. The price variability in a heterogeneous information economy is shown to be 20% to 46% higher than in an otherwise equivalent economy in which all signals are publicly announced. I. Introduction A common theme of the rational expectations literature is the ability of prices to convey information. A question is the extent to which this informational role induces additional variability in prices. Grundy and McNichols (1989) present a rational expectations model with multiple rounds of trade preceding a final consumption date. They show that the revelation of existing private information through price changes can be the sole cause of the price variability: equilibrium prices can change even in the absence of any change in supply or the arrival of any new information beyond the observation that the price itself has changed. We examine the link between the informational role of prices and price variability in a multi-period model with heterogeneous information arriving, and consumption taking place, at each trading date. Our goal is to obtain a comparison of price variability in a world of heterogeneous information with variability in an otherwise equivalent homogeneous information economy in which, in effect, all private signals are publicly announced and