Learning about the Interdependence between the Macroeconomy and the Stock Market

Fabio Milani ()

No 70819, Working Papers from University of California-Irvine, Department of Economics

Abstract: How strong is the interdependence between the macroeconomy and the stock market? This paper estimates a New Keynesian general equilibrium model, which includes a wealth effect from asset price fluctuations to consumption, to assess the quantitative importance of interactions among the stock market, macroeconomic variables, and monetary policy. The paper relaxes the assumption of rational expectations and assumes that economic agents learn over time and form near-rational expectations from their perceived model of the economy. The stock market, therefore, affects the economy through two channels: through a traditional ``wealth effect" and through its impact on agents' expectations. Monetary policy decisions also affect and are potentially affected by the stock market. The empirical results show that the direct wealth effect is modest, but asset price fluctuations have had important effects on output expectations. Shocks in the stock market can account for a large portion of output fluctuations. The effect on expectations, however, has declined over time.

Keywords: Stock market; Wealth channel; Monetary policy; Constant-gain learning; Bayesian estimation; Expectations (search for similar items in EconPapers)
JEL-codes: E32 E44 E52 E58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-opm
Date: 2008-05
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Persistent link: http://EconPapers.repec.org/RePEc:irv:wpaper:070819

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