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Learning about the Interdependence between the Macroeconomy and the Stock Market

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  • Fabio Milani

    ()
    (Department of Economics, University of California-Irvine)

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.

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File URL: http://www.economics.uci.edu/files/economics/docs/workingpapers/2007-08/milani-19.pdf
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Bibliographic Info

Paper provided by University of California-Irvine, Department of Economics in its series Working Papers with number 070819.

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Length: 31 pages
Date of creation: May 2008
Date of revision:
Handle: RePEc:irv:wpaper:070819

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Related research

Keywords: Stock market; Wealth channel; Monetary policy; Constant-gain learning; Bayesian estimation; Expectations;

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Citations

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Cited by:
  1. Fabio Milani, 2009. "Expectations, Learning, and the Changing Relationship between Oil Prices and the Macroeconomy," Working Papers 080923, University of California-Irvine, Department of Economics.
  2. Funke, Michael & Paetz, Michael & Pytlarczyk, Ernest, 2011. "Stock market wealth effects in an estimated DSGE model for Hong Kong," Economic Modelling, Elsevier, vol. 28(1), pages 316-334.
  3. Lengnick, Matthias & Wohltmann, Hans-Werner, 2010. "Agent-based financial markets and New Keynesian macroeconomics: A synthesis," Economics Working Papers 2010,10, Christian-Albrechts-University of Kiel, Department of Economics.
  4. Milani, Fabio, 2011. "The impact of foreign stock markets on macroeconomic dynamics in open economies: A structural estimation," Journal of International Money and Finance, Elsevier, vol. 30(1), pages 111-129, February.
  5. Challe, Edouard & Giannitsarou, Chryssi, 2014. "Stock prices and monetary policy shocks: A general equilibrium approach," Journal of Economic Dynamics and Control, Elsevier, vol. 40(C), pages 46-66.
  6. Francesco Furlanetto, 2011. "Does Monetary Policy React to Asset Prices? Some International Evidence," International Journal of Central Banking, International Journal of Central Banking, vol. 7(3), pages 91-111, September.
  7. Castelnuovo, Efrem & Nisticò, Salvatore, 2010. "Stock market conditions and monetary policy in a DSGE model for the U.S," Journal of Economic Dynamics and Control, Elsevier, vol. 34(9), pages 1700-1731, September.
  8. Fabio Milani, 2009. "The Effect of Global Output on U.S. Inflation and Inflation Expectations: A Structural Estimation," Working Papers 080920, University of California-Irvine, Department of Economics.

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