Financial wealth, investment, and confidence in a DSGE model for China

Based on a DSGE model, we investigate the interconnection between China’s stock market and macroeconomic cycles. Our results show that consumption, investment, and capacity utilization exhibit significant and positive responses to stock market booms triggered by the financial and confidence shocks, while the responses of inflation are more muted and insignificant. There is a significant ‘leaning-against-the-wind’ reaction of China’s monetary policy to the credit-to-GDP gap at business cycle frequencies. Decomposing stock prices into fundamental values influenced by the financial shock and bubbles driven by the confidence shock, the confidence shock’s contribution to stock return fluctuations is estimated to be 14.8%.