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Learning about the Interdependence between the Macroeconomy and the Stock Market

  • Fabio Milani

    ()

    (Department of Economics, University of California-Irvine)

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/docs/workingpapers/2007-08/milani-19.pdf
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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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