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Inelastic Markets Hypothesis

| | Posted in: Big Ideas

Is aggregate U.S. stock market value sensitive to flows of new funds (inelastic)? In their October 2020 paper entitled "In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis", Xavier Gabaix and Ralph Koijen analyze aggregate stock market fluctuations  in relation to flows of money into and out of stocks by different investor categories. They key on difficulties in satisfying demand for stocks/cash when money enters/exits the market. For example, institutions have reasonably rigid equity allocations, many individuals exhibit strong buy-and-hold inertia and hedge funds are not large enough to accommodate large inflows. In other words, households and their institutional proxies require considerable incentive to deviate from established equity allocations. As a result, relative modest flows have large impacts on prices (are inelastic). They further analyze how key tenets of macro-finance change if, in contrast to conventional belief, markets are inelastic. Using data on money flows to/from U.S. stocks across different investor categories as available during 1993 through 2018, and contemporaneous U.S. stock market level, they find that:

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