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

Quarterly Review 1712 | Winter 1993

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Author

S. Rao Aiyagari

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

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.


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