Ambiguity-driven asset price misalignment and its policy implications

Purpose Implications of ambiguity for the dynamics of asset prices and wealth distribution are the chief concern of this study. Design/methodology/approach In a continuous-time stochastic macro setting characterized by heterogeneous agents and financial friction with perfect “skin-in-the-game” for productive agents, we derive analytically and then illustrate numerically how ambiguity aversion would impinge on the agents’ consumption share and precautionary motives, sowing the seeds for asset price misalignment and thereby calling for appropriate policy response. Findings The agents’ ambiguity-aversion triggers a low real risk-free rate, fewer consumption shares, higher precautionary savings and wealth redistribution, inducing misalignment in asset prices. The distortion entails welfare loss for all agents, making a case for conventional monetary and fiscal policy design and analysis. For a given degree of ambiguity aversion, the dividend and capital value taxations could mitigate the asset price misalignment though causing a welfare loss as they are distortionary in turn. However, conventional monetary policy could lessen the asset price distortion and improve the welfare of at least a subset of agents if it is fine-tuned well. Originality/value Characterizations of ambiguity-driven asset price misalignments along with redistributive implications of ambiguity and their reflections for asset price volatility, leverage, welfare and fiscal and monetary policy conduct and analysis are the key contributions of this study.