...dual role of prices. By “dual role”, we mean that prices not only reflect the underlying economic fundamentals, they are also an imperative to action. That is, prices induce actions on the part of the economic agents. If some actions are the consequence of binding constraints and exert harmful spillover effects on others, then price changes can bring about amplifying spillover effects that disrupt the smooth working of the market, and sometimes shut down the market completely.
Endogenous Extreme Events and the Dual Role of Prices
It is important to appreciate the dual role of prices, although this is a subtle concept. Prices first reflect exogenous events as markets reflect new information that impacts expectations. If inflation increases, for example, there will be a reaction in prices as investors adjust their expectations. However, investor will not just react to new information and adjust their portfolios. They will also adjust or take action when they see prices change.
The reaction to price movements may be independent of the change in exogenous information. The reaction could be due to uncertainty about what information is being displayed in the price. A reaction to price behavior independent of exogenous information is an endogenous reaction. Investors react to prices rather than to any other information. This can lead to extremes and explain most of the price movement during the day. One of the most important tasks for an investor is understanding the difference between these price moves and appreciating the action that stems from the distinction between exogenous and endogenous moves.
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