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Real-Financial Interaction: A Reconsideration of the Blanchard Model with a State-of-Market Dependent Reaction Coefficient

We reformulate and extend the Blanchard model of output dynamics, the stock market and interest rates that studies Keynesian IS-LM analysis from the perspective of a richer array of short-term bonds. Thus investment demand now depends on Tobin's average q in the place of the real rate of interest and as a result share price dynamics feed back into the real sector, thereby creating the link for the real-financial interaction studied by Blanchard. We reconsider the results achieved by Blanchard without use of logarithms and other simplifications in the expression for the substitutability and imperfect forecasts of capital gains in the place of Blanchard's limit case of perfect substitutes and myopic perfect foresight. Our more general framework, and in particular the assumption of a state-of-the market dependent speed of reaction to expected asset return differentials, allows us to develop a mode of dynamic analysis that provides an alternative to the conventional jump variable technique of the perfect limit cases. We show how as a consequence the stock market dynamics can display periods of bull and bear markets having both activated and tranquil phases that give rise to a variety of adjustment patterns.

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File URL: http://www.finance.uts.edu.au/research/wpapers/wp111.pdf
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Paper provided by Finance Discipline Group, UTS Business School, University of Technology, Sydney in its series Working Paper Series with number 111.

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Date of creation: 01 Mar 2001
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Handle: RePEc:uts:wpaper:111
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Web page: http://www.uts.edu.au/about/uts-business-school/finance

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  1. repec:att:wimass:9530 is not listed on IDEAS
  2. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
  3. repec:cup:cbooks:9780521643511 is not listed on IDEAS
  4. Carl Chiarella & Peter Flaschel & Willi Semmler, 2003. "Real-Financial Interaction: Implications of Budget Equations and Capital Accumulation," Working Paper Series 127, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
  5. Chiarella Carl & Semmler Willi & Mittnik Stefan & Zhu Peiyuan, 2002. "Stock Market, Interest Rate and Output: A Model and Estimation for US Time Series Data," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 6(1), pages 1-39, April.
  6. Buiter, Willem H, 1984. "Saddlepoint Problems in Continuous Time Rational Expectations Models: A General Method and Some Macroeconomic Examples," Econometrica, Econometric Society, vol. 52(3), pages 665-80, May.
  7. Chiarella, Carl, 1986. "Perfect foresight models and the dynamic instability problem from a higher viewpoint," Economic Modelling, Elsevier, vol. 3(4), pages 283-292, October.
  8. Sargent, Thomas J & Wallace, Neil, 1973. "The Stability of Models of Money and Growth with Perfect Foresight," Econometrica, Econometric Society, vol. 41(6), pages 1043-48, November.
  9. Chiarella, Carl, 1990. "Excessive exchange rate variability : A possible explanation using nonlinear economic dynamics," European Journal of Political Economy, Elsevier, vol. 6(3), pages 315-352, December.
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