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:
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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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