We develop a framework to theoretically and empirically analyze the fluctuations of the aggregate stock market. Households allocate capital to institutions, which are fairly constrained, for example operating with a mandate to maintain a fixed equity share or with moderate scope for variation in response to changing market conditions. As a result, the price elasticity of demand of the aggregate stock market is small, and flows in and out of the stock market have large impacts on prices.
Using the recent method of granular instrumental variables, we find that investing $1 in the stock market increases the market's aggregate value by about $5. We also develop a new measure of capital flows into the market, consistent with our theory. We relate it to prices, macroeconomic variables, and survey expectations of returns.
We analyze how key parts of macro-finance change if markets are inelastic. We show how general equilibrium models and pricing kernels can be generalized to incorporate flows, which makes them amenable to use in more realistic macroeconomic models and to policy analysis.
Our framework allows us to give a dynamic economic structure to old and recent datasets comprising holdings and flows in various segments of the market. The mystery of apparently random movements of the stock market, hard to link to fundamentals, is replaced by the more manageable problem of understanding the determinants of flows in inelastic markets. We delineate a research agenda that can explore a number of questions raised by this analysis, and might lead to a more concrete understanding of the origins of financial fluctuations across markets.
We thank Ehsan Azarmsa, Aditya Chaudhry, Antonio Coppola, Zhiyu Fu, Dong Ryeol Lee, Hae-Kang Lee, Simon Oh, and Lingxuan Wu for excellent research assistance. We thank Francesca Bastianello, Jean-Philippe Bouchaud, Michael Brandt, John Campbell, Francesco Franzoni, Robin Greenwood, Valentin Haddad, Lars Hansen, Sam Hanson, John Heaton, Tim Johnson, Arvind Krishnamurthy, Spencer Kwon, John Leahy, Hanno Lustig, Alan Moreira, Knut Mork, Toby Moskowitz, Stefan Nagel, Jonathan Parker, Lasse Pedersen, Joel Peress, Jean-Charles Rochet, Ivan Shaliastovich, Andrei Shleifer, Jeremy Stein, Johannes Stroebel, Larry Summers, Adi Sunderam, Jean Tirole, Harald Uhlig, Dimitri Vayanos, Motohiro Yogo, and participants at various seminars for comments. Gabaix thanks the Sloan Foundation for financial support. Koijen acknowledges financial support from the Center for Research in Security Prices at the University of Chicago Booth School of Business. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.