Explaining Financial Market Facts: The Importance of Incomplete Markets and Transaction Costs

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Creator Series Issue number
  • Vol. 17, No. 1
Date created
  • 1993 Winter
Abstract

  • In this article, I suggest that incomplete markets and transaction costs are crucial for explaining the high equity premium and the low risk-free rate. I first demonstrate the failure of the complete frictionless markets model in explaining these return puzzles and then show how introducing incomplete markets and transaction costs can lead to success. Additionally, I explain how these features lead to predictions concerning individual consumptions, wealths, portfolios, and asset market transactions that are in better agreement with the facts than the predictions of the complete frictionless markets model.

Related information

  • Isolated portions of this article are borrowed from an article in the Journal of Monetary Economics (June 1991, vol. 27, no. 3, pp. 311-31): "Asset Returns With Transactions Costs and Uninsured Individual Risk" by S. Rao Aiyagari and Mark Gertler, with the permission of Elsevier Science Publishers B. V. (North-Holland). © All rights reserved. https://doi.org/10.1016/0304-3932(91)90012-D

Corporate Author
  • Federal Reserve Bank of Minneapolis. Research Department
Publisher
  • Federal Reserve Bank of Minneapolis
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