Stock market conditions and monetary policy in a DSGE model for the U.S.

This paper investigates the interactions between stock market fluctuations and monetary policy within a DSGE model for the U.S. economy. First, we design a framework in which fluctuations in households financial wealth are allowed but not necessarily required to exert an impact on current consumption. This is due to the interaction, in the financial markets, of long-time traders holding wealth accumulated over time with newcomers holding no wealth at all. Importantly, we introduce nominal wage stickiness to induce pro-cyclicality in real dividends. Additional nominal and real frictions are modeled to capture the pervasive macroeconomic persistence of the observables employed to estimate our model. We fit our model to post-WWII U.S. data, and report three main results. First, the data strongly support a significant role of stock prices in affecting real activity and the business cycle. Second, our estimates also identify a significant and counteractive response of the Fed to stock-price fluctuations. Third, we derive from our model a microfounded measure of financial slack, the "stock-price gap", which we then contrast to alternative ones, currently used in empirical studies, to assess the properties of the latter to capture the dynamic and cyclical implications of our DSGE model. The behavior of our "stock-price gap" is consistent with the episodes of stock-market booms and busts occurred in the post-WWII, as reported by independent analyses, and closely correlates with the current financial meltdown. Typically employed proxies of financial slack such as detrended log-indexes or growth rates show limited capabilities of capturing the implications of our model-consistent index of financial stress. Cyclical properties of the model as well as counterfactuals regarding shocks to our measure of financial slackness and monetary policy shocks are also proposed. (C) 2010 Elsevier B.V. All rights reserved.