On information efficiency and financial stability

TL;DR

This paper models an asset market with informed and non-informed traders, showing that non-informed traders significantly impact trading activity only when the market is nearly information efficient, implying a link between efficiency and bubbles.

Contribution

It introduces a simple model demonstrating the role of non-informed traders in market dynamics and their dependence on information efficiency for influencing trading activity.

Findings

Non-informed traders contribute significantly only in nearly efficient markets

Market efficiency is linked to the emergence of bubbles

Disrupting market efficiency could curb bubble formation

Abstract

We study a simple model of an asset market with informed and non-informed agents. In the absence of non-informed agents, the market becomes information efficient when the number of traders with different private information is large enough. Upon introducing non-informed agents, we find that the latter contribute significantly to the trading activity if and only if the market is (nearly) information efficient. This suggests that information efficiency might be a necessary condition for bubble phenomena, induced by the behavior of non-informed traders, or conversely that throwing some sands in the gears of financial markets may curb the occurrence of bubbles.