Information, heterogeneity and market incompleteness

Information is “market-consistent” if agents only use market prices to infer the underlying states of the economy. This paper applies this concept to a stochastic growth model with incomplete markets and heterogeneous agents. The economy with market-consistent information can never replicate the full information equilibrium, and there are substantial differences in impulse responses to aggregate productivity shocks. These results are robust to the introduction of a noisy public signal and aggregate financial markets. We argue that the principle of market-consistent information should be applied to any model with incomplete markets.