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

  • Hylton Hollander

    ()

    (Department of Economics, University of Stellenbosch)

  • Guangling Liu

    ()

    (Department of Economics, University of Stellenbosch)

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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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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