Market Turmoil and Destabilizing Speculation

This paper explores how speculators can destabilize financial markets by amplifying negative shocks in periods of market turmoil. I propose a dynamic trading model with two types of investors — long-term and speculative — who interact in a market with search frictions. During periods of turmoil created by an uncertainty shock, speculators react to declining asset prices by liquidating their holdings in hopes of buying them back later at a gain, despite the asset's cash flows remaining the same throughout. Interestingly, I show that a reduction in search frictions leads to more severe fluctuations in asset prices. At the root of this result are the strategic complementarities between speculators expected to follow similar strategies in the future.