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The Increased Importance of Asset Price Misalignments for Business Cycle Dynamics

Author

Listed:
  • 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.

Suggested Citation

  • Bask, Mikael & Madeira, João, 2011. "The Increased Importance of Asset Price Misalignments for Business Cycle Dynamics," Working Paper Series 2011:12, Uppsala University, Department of Economics.
    • Handle: RePEc:hhs:uunewp:2011_012
    as

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    File URL: http://uu.diva-portal.org/smash/get/diva2:422649/FULLTEXT01.pdf
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    References listed on IDEAS

    as
    1. Ricardo Reis & Vasco Curdia, 2009. "Correlated Disturbances and U.S. Business Cycles," 2009 Meeting Papers 129, Society for Economic Dynamics.
    2. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
    3. Paul Grauwe, 2011. "Animal spirits and monetary policy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 423-457, June.
    Full references (including those not matched with items on IDEAS)

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    Blog mentions

    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 2011-06-27 04:20:19

    Citations

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    Cited by:

    1. Alexey Vasilenko, 2017. "Should Monetary Authorities Prick Asset Price Bubbles? Evidence from a New Keynesian Model with an Agent-Based Financial Market," HSE Working papers WP BRP 182/EC/2017, National Research University Higher School of Economics.

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    More about this item

    Keywords

    Asset Price Bubble; Bayesian Technique; Business Cycle; DSGE Model; Fundamental Analysis; Trend Extrapolation;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises

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