Reconnecting investment to stock markets: the role of corporate net worth evaluation

Following recent studies by the Bank of England that the low financial market confidence and low expectations about private sector profits over the next three years has lead to unusually low price-to-book ratios, we incorporate a stock market mechanism in a general equilibrium framework. More specifically, we introduce an endogenous wedge between market and book value of capital, and make investment a function of it in a standard financial accelerator model. The price wedge is driven by an information set containing expectations about the future state of the economy. The result is that the impulse responses to exogenous disturbances are on average two to three times more volatile than in the benchmark financial accelerator model. More- over, the model improves the matching of firm variables and financial rates to US data compared to the standard financial accelerator model. We also derive a model based quadratic loss function and measure the extent to which monetary policy can feed a bubble by further loosening the credit market frictions that entrepreneurs face. A policy that explicitly targets stock market developments can be shown to improve welfare in terms of minimizing the consumption losses of consumers, even when we account for incomplete information of central bankers regarding the current state of the economy.