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Federal Reserve Bank of Minneapolis
Quarterly Review
Explaining financial market facts: the importance of incomplete markets and transaction costs
S. Rao Aiyagari
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.


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S. Rao Aiyagari, "Explaining financial market facts: the importance of incomplete markets and transaction costs" , Federal Reserve Bank of Minneapolis, Quarterly Review, issue Win, pages 17-31, 1993.
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Keywords: Interest rates
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Fed-in-Print is the central catalog of publications within the Federal Reserve System. It is managed and hosted by the Economic Research Division, Federal Reserve Bank of St. Louis.

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