Does Speculative Activity Have Real Effects

Investors with recursive preferences disagree on real productivity and extraneousrisks in a production economy with non-smooth adjustment costs. Speculation in financialmarkets, especially on extraneous risks, can be long-lasting and significantlyimpact the real economy. It can either decrease or increase real investment and assetprices depending on whether investors’ EIS is less or greater than 1. It may makethe economy switch between production and pure exchange, and speculation withextraneous risk always increases asset volatility in the pure-exchange phase. Anyidiosyncratic extraneous risk becomes systematic if investors disagree on it and tradeit in financial markets. With the EIS greater than 1, speculation can generate variousboom-and-bust patterns observed in the recent US housing markets.