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Linking Real Activity and Financial Markets: The Bonds, Equity, and Money (BEAM) Model

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  • Céline Gauthier
  • Fu Chun Li
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    Abstract

    The authors estimate a small monthly macroeconometric model (BEAM, for bonds, equity, and money) of the Canadian economy built around three cointegrating relationships linking financial and real variables over the 1975–2002 period. One of the cointegrating relationships allows the identification of a supply shock as the only shock that permanently affects the stock market, and a demand shock that leads to important transitory stock market overvaluation. The authors propose a monetary policy reaction function in which the impact of a permanent inflation shock on the overnight rate is simulated and the future path of the overnight rate adjusted accordingly, to prevent any forecast persistent deviation from the inflation target. They introduce a technical innovation by showing under which conditions permanent shocks can be identified in a vector error-correction model with exogenous variables.

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    Bibliographic Info

    Paper provided by Bank of Canada in its series Working Papers with number 06-42.

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    Length: 43 pages
    Date of creation: 2006
    Date of revision:
    Handle: RePEc:bca:bocawp:06-42

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    Web page: http://www.bank-banque-canada.ca/

    Related research

    Keywords: Financial markets; Financial stability;

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    References

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    1. Rapach, David E, 2003. " International Evidence on the Long-Run Impact of Inflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 23-48, February.
    2. Andrew Atkeson & Lee E. Ohanian., 2001. "Are Phillips curves useful for forecasting inflation?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-11.
    3. Katharine S. Neiss & Edward Nelson, 2001. "The real interest rate gap as an inflation indicator," Bank of England working papers 130, Bank of England.
    4. Wickens, Michael R., 1996. "Interpreting cointegrating vectors and common stochastic trends," Journal of Econometrics, Elsevier, vol. 74(2), pages 255-271, October.
    5. Lutkepohl, Helmut & Reimers, Hans-Eggert, 1992. "Impulse response analysis of cointegrated systems," Journal of Economic Dynamics and Control, Elsevier, vol. 16(1), pages 53-78, January.
    6. Johansen, Soren, 1992. "Cointegration in partial systems and the efficiency of single-equation analysis," Journal of Econometrics, Elsevier, vol. 52(3), pages 389-402, June.
    7. Kilian, Lutz & Taylor, Mark P., 2001. "Why is it so difficult to beat the random walk forecast of exchange rates?," Working Paper Series 0088, European Central Bank.
    8. Olivier Jean Blanchard & Danny Quah, 1988. "The Dynamic Effects of Aggregate Demand and Supply Disturbance," Working papers 497, Massachusetts Institute of Technology (MIT), Department of Economics.
    9. Timothy Cogley & Thomas Sargent, . "Evolving Post-World War II U.S. Inflation Dynamics," Working Papers 2132872, Department of Economics, W. P. Carey School of Business, Arizona State University.
    10. Frank Smets & Ignazio Angeloni & Gunter Coenen, 2003. "Persistence, the Transmission Mechanism and Robust Monetary Policy," Computing in Economics and Finance 2003 137, Society for Computational Economics.
    11. Pesaran, M. Hashem & Shin, Yongcheol & Smith, Richard J., 2000. "Structural analysis of vector error correction models with exogenous I(1) variables," Journal of Econometrics, Elsevier, vol. 97(2), pages 293-343, August.
    12. Michael R. Wickens & Roberto Motto, 2001. "Estimating shocks and impulse response functions," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 16(3), pages 371-387.
    13. Tor Jacobson & Per Jansson & Anders Vredin & Anders Warne, 2001. "Monetary policy analysis and inflation targeting in a small open economy: a VAR approach," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 16(4), pages 487-520.
    14. Robert G. King & Charles I. Plosser & James H. Stock & Mark W. Watson, 1992. "Stochastic Trends and Economic Fluctuations," NBER Working Papers 2229, National Bureau of Economic Research, Inc.
    15. Yang, M., 1995. "On Identifying Permanent and Transitory Shocks in VAR Models," Papers 95-5, New South Wales - School of Economics.
    16. Coenen, Gunter, 2007. "Inflation persistence and robust monetary policy design," Journal of Economic Dynamics and Control, Elsevier, vol. 31(1), pages 111-140, January.
    17. David Longworth, 2003. "Money in the Bank (of Canada)," Technical Reports 93, Bank of Canada.
    18. Cassola, Nuno & Morana, Claudio, 2002. "Monetary policy and the stock market in the euro area," Working Paper Series 0119, European Central Bank.
    19. Céline Gauthier & Christopher Graham & Ying Liu, 2004. "Financial Conditions Indexes for Canada," Working Papers 04-22, Bank of Canada.
    20. Celine Gauthier & David Tessier, 2002. "Supply Shocks and Real Exchange Rate Dynamics: Canadian Evidence," Working Papers 02-31, Bank of Canada.
    21. Ploberger, Werner & Kramer, Walter & Kontrus, Karl, 1989. "A new test for structural stability in the linear regression model," Journal of Econometrics, Elsevier, vol. 40(2), pages 307-318, February.
    22. Shamik Dhar & Darren Pain & Ryland Thomas, 2000. "A small structural empirical model of the UK monetary transmission mechanism," Bank of England working papers 113, Bank of England.
    23. Blanchard, Olivier J, 1981. "Output, the Stock Market, and Interest Rates," American Economic Review, American Economic Association, vol. 71(1), pages 132-43, March.
    24. Halbert White, 2000. "A Reality Check for Data Snooping," Econometrica, Econometric Society, vol. 68(5), pages 1097-1126, September.
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    Cited by:
    1. Maral Kichian, 2012. "Financial Conditions and the Money-Output Relationship in Canada," Working Papers 12-33, Bank of Canada.

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