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The Increased Importance of Asset Price Misalignments for Business Cycle Dynamics

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Author Info

  • Bask, Mikael

    ()
    (Department of Economics)

  • Madeira, João

    ()
    (University of Exeter Business School)

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.

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Bibliographic Info

Paper provided by Uppsala University, Department of Economics in its series Working Paper Series with number 2011:12.

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Length: 32 pages
Date of creation: 08 Jun 2011
Date of revision:
Handle: RePEc:hhs:uunewp:2011_012

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Postal: Department of Economics, Uppsala University, P. O. Box 513, SE-751 20 Uppsala, Sweden
Phone: + 46 18 471 25 00
Fax: + 46 18 471 14 78
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Web page: http://www.nek.uu.se/
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Related research

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

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  1. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. The Increased Importance of Asset Price Misalignments for Business Cycle Dynamics
    by Christian Zimmermann in NEP-DGE blog on 2011-06-26 23:20:19

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