Asset pricing dynamics in economies with limited market participation: A continuous-time approach

We develop a continuous-time stochastic dynamic general equilibrium model featuring three agents with limited participation in capital markets. This model is designed to address economies characterized by significant financial frictions. We solve the 2-dimensional macro-finance model using approximation and numerical methods. Our findings reveal nuanced asset pricing dynamics. Increasing a household’s share of total wealth continuously reduces asset prices. Conversely, an increase in the corporate sector’s wealth share initially raises asset prices before causing a decline. Simulations of Iran’s justice policy demonstrate that when stock market participation surpasses a critical threshold, redistributing wealth from the corporate sector to households results in higher asset prices. This simulation helps us answer the question for the first time why the Tehran stock market experienced stunning growth in 2020. These results provide valuable insights into the interaction between financial frictions and asset pricing, with important implications for policy design in economies with limited financial inclusion.