Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 11/2010:
Stock market conditions and monetary policy in an DSGE model for the US

Efrem Castelnuovo () and Salvatore Nisticò ()

Abstract: This paper investigates the relationship between stock market fluctuations and monetary policy in a DSGE model for the US economy. We initially adopt a framework in which fluctuations in households’ financial wealth are allowed – but not required – to influence current consumption. This is due to interaction in the financial markets between long-time traders holding wealth accumulated over time and zero-wealth newcomers. Importantly, we introduce nominal wage stickiness to induce pro-cyclicality in real dividends. Additional nominal and real frictions are modeled to capture the pervasive macroeconomic persistence of the observables used to estimate our model. We fit our model to US post-WWII data and report three main results. First, the data strongly support a significant impact of stock prices on real activity and business cycles. Second, our estimates also identify a significant and counteractive Fed response to stock-price fluctuations. Third, we derive from our model a microfounded measure of financial slack – the stock-price gap – which we then compare with alternative measures, currently used in empirical studies, to assess the properties of the latter for capturing the dynamic and cyclical implications of our DSGE model. The behavior of our stock-price gap is consistent with the episodes of stock-market booms and busts in the post-WWII period, as reported by independent analyses, and closely correlates with the current financial meltdown. Typically, the proxies used for financial slack, such as detrended log-indexes or growth rates, show limited capabilities of capturing the implications of our model-consistent index of financial stress. Cyclical properties of the model as well as counterfactuals regarding shocks to our measure of financial slackness and monetary policy shocks are also proposed.

Keywords: stock prices; monetary policy; Bayesian estimation; wealth effects; (follow links to similar papers)

JEL-Codes: E12; E44; E52; (follow links to similar papers)

68 pages, April 28, 2010

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This paper is published as:
Castelnuovo, Efrem and Salvatore Nisticò, (2010), 'Stock market conditions and monetary policy in an DSGE model for the US', Journal of Economic Dynamics and Control, Vol. 34(9), pages 1700-1731

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