Scandinavian Working Papers in Economics

Working Paper Series,
Uppsala University, Department of Economics

No 2011:12: The Increased Importance of Asset Price Misalignments for Business Cycle Dynamics

Mikael Bask () and João Madeira ()
Additional contact information
Mikael Bask: Department of Economics, Postal: Department of Economics, Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden
João Madeira: University of Exeter Business School, Postal: Streatham Court, Streatham Campus, University of Exeter, Exeter, EX4 4ST, U.K.

Abstract: We outline a dynamic stochastic general equilibrium (DSGE) model with trend extrapolation in asset pricing that we fit to quarterly U.S. macroeconomic time series with Bayesian techniques. To be more precise, we modify the DSGE model in Smets and Wouters (2007) by incorporating asset traders who use a mix of fundamental analysis and trend extrapolation in asset pricing. We conclude that trend extrapolation in asset pricing is quantitatively relevant, statistically significant and results in a substantial improvement of the model’s fit to the data. We also find that the strength in trend extrapolation is much stronger during the Great Moderation than it was prior to this period. Moreover, allowing for asset mispricing leads to more pronounced hump-shaped dynamics of the asset price and investment. Thus, asset price misalignments should be an important ingredient in DSGE models that aim to understand business cycles dynamics in general and the interaction between the real and financial sectors in particular.

Keywords: Asset Price Bubble; Bayesian Technique; Business Cycle; DSGE Model; Fundamental Analysis; Trend Extrapolation

JEL-codes: E32; E44; G01

32 pages, June 8, 2011

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