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Noise Fischer Black The Journal of Finance, Vol. 41, No. 3, Papers and Proceedings of the Forty-Fourth Annual Meeting of the America Finance Association, New York, New York, December 28-30, 1985. (Jul., 1986), pp. 529-543.
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Fischer Black President of the American Finance Association



JULY 1986

The effects of noise on the world, and on our views of the world, are profound. Noise in the sense of a large number of small events is often a causal factor much morepowerful than a small number of large events can be. Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets. Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies. Noise in the form of uncertainty about future tastes and technology by sector causes business cycles, and makes them highlyresistant to improvement through government intervention. Noise in the form of expectations that need not follow rational rules causes inflation to be what it is, at least in the absence of a gold standard or fixed exchange rates. Noise in the form of uncertainty about what relative prices would be with other exchange rates makes us think incorrectly that changes in exchange rates or inflationrates cause changes in trade or investment flows or economic activity. Most generally, noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work. We are forced to act largely in the dark.

I USE THE WORD "noise" in several senses in this paper. In my basic model of financial markets, noise is contrasted with information. Peoplesometimes trade on information in the usual way. They are correct in expecting to make profits from these trades. On the other hand, people sometimes trade on noise as if it were information. If they expect to make profits from noise trading, they are incorrect. However, noise trading is essential to the existence of liquid markets. In my model of the way we observe the world, noise is what makesour observations imperfect. It keeps us from knowing the expected return on a stock or portfolio. It keeps us from knowing whether monetary policy affects inflation or unemployment. It keeps us from knowing what, if anything, we can do to make things better. In my model of inflation, noise is the arbitrary element in expectations that leads to an arbitrary rate of inflation consistent with...
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