Best friend or worst enemy? : dynamics and multiple equilibria with financial arbitrage, production and collateral constraints

We develop a tractable model to study the macroeconomic impacts of limited arbitrage by linking arbitrage activities with the macroeconomy through collateralization. We show that the interactions between speculative trading and the business cycle can work as a powerful transmission mechanism, where trivial shocks spread, amplify, and trigger simultaneous arbitrage failures and recessions. Collateralization adds extra value to real-sector investments, and ultimately helps boost aggregate production. We solve for the model dynamics analytically and characterize multiple equilibria. Through regime shifts, we account for the non-linear aspects of financial crises as well as the slow and incomplete post-crisis recoveries