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The equity price channel in a New-Keynesian DSGE model with financial frictions and banking

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  • Hylton Hollander

    ()
    (Department of Economics, University of Stellenbosch)

  • Guangling Liu

    ()
    (Department of Economics, University of Stellenbosch)

Abstract

This paper studies the role of the equity price channel in business cycle fluctuations, and highlights the equity price channel as a different aspect to general equilibrium models with financial frictions and, as a result, emphasizes the systemic influence of financial markets on the real economy. We develop a canonical New-Keynesian DSGE model with a tractable role for the equity market in banking, entrepreneur and household economic activities. The model is estimated with Bayesian techniques using U.S. data over the sample period 1982Q01 - 2012Q01. We show that a New Keynesian DSGE model with an equity price channel well mimics the U.S. business cycle. The model reproduces the strong procyclicality of the equity market. The equity price channel significantly exacerbates business cycle fluctuations through both financial accelerator and bank capital channels. Our results support the increasing emphasis on common equity capital in Basel III regulations. This is beneficial in terms of financial stability, but amplifies and propagates shocks to the real economy.

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File URL: http://www.ekon.sun.ac.za/wpapers/2013/wp162013/wp-16-2013.1.pdf
File Function: Revised version (version 2), 2014
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Bibliographic Info

Paper provided by Stellenbosch University, Department of Economics in its series Working Papers with number 16/2013.

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Date of creation: 2013
Date of revision: 2014
Handle: RePEc:sza:wpaper:wpapers192

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Keywords: Equity price channel; asset pricing; financial frictions; bank capital; New-Keynesian; Bayesian;

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  1. Andrea Gerali & Stefano Neri & Luca Sessa & Federico M. Signoretti, 2010. "Credit and banking in a DSGE model of the euro area," Temi di discussione (Economic working papers) 740, Bank of Italy, Economic Research and International Relations Area.
  2. Smets, Frank & Wouters, Rafael, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," CEPR Discussion Papers 6112, C.E.P.R. Discussion Papers.
  3. Harald Uhlig, 2007. "Explaining Asset Prices with External Habits and Wage Rigidities in a DSGE Model," American Economic Review, American Economic Association, vol. 97(2), pages 239-243, May.
  4. Michał Brzoza-Brzezina & Marcin Kolasa & Krzysztof Makarski, 2011. "The anatomy of standard DSGE models with financial frictions," National Bank of Poland Working Papers 80, National Bank of Poland, Economic Institute.
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  6. Meh, Césaire A. & Moran, Kevin, 2010. "The role of bank capital in the propagation of shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 555-576, March.
  7. de Walque, Gregory & Pierrard, Olivier & Rouabah, Abdelaziz, 2009. "Financial (In)stability, Supervision and Liquidity Injections: A Dynamic General Equilibrium Approach," CEPR Discussion Papers 7202, C.E.P.R. Discussion Papers.
  8. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series WP-99-14, Federal Reserve Bank of Chicago.
  9. Matteo Iacoviello, 2005. "House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle," American Economic Review, American Economic Association, vol. 95(3), pages 739-764, June.
  10. Castelnuovo , Efrem & Nisticò, Salvatore, 2010. "Stock market conditions and monetary policy in an DSGE model for the US," Research Discussion Papers 11/2010, Bank of Finland.
  11. Nobuhiro Kiyotaki & John Moore, 1995. "Credit Cycles," NBER Working Papers 5083, National Bureau of Economic Research, Inc.
  12. Bojan Markovic, 2006. "Bank capital channels in the monetary transmission mechanism," Bank of England working papers 313, Bank of England.
  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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Cited by:
  1. Federico GIRI, 2014. "Does Interbank Market Matter for Business Cycle Fluctuation? An Estimated DSGE Model with Financial Frictions for the Euro Area," Working Papers 398, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.

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