Working Paper: CEPR ID: DP13866
Authors: Klaus Adam; Sebastian Merkel
Abstract: We present a simple model that quantitatively replicates the behavior of stock prices and business cycles in the United States. The business cycle model is standard, except that it features extrapolative belief formation in the stock market, in line with the available survey evidence. Extrapolation amplifies the price effects of technology shocks and - in response to a series of positive technology surprises - gives rise to a large and persistent boom and bust cycle in stock prices. Boom-bust dynamics are more likely when the risk-free interest rate is low because low rates strengthen belief-based amplification. Stock price cycles transmit into the real economy by generating inefficient price signals for the desirability of new investment. The model thus features a `financial accelerator', despite the absence of financial frictions. The financial accelerator causes the economy to experience persistent periods of over- and under-accumulation of capital.
Keywords: Stock Price Cycles; Business Cycles
JEL Codes: E32; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| extrapolative belief formation in the stock market (G41) | amplification of price effects of technology shocks (E39) |
| positive technology surprises (D80) | boom in stock prices (E32) |
| boom in stock prices (E32) | increased investment (E22) |
| boom in stock prices (E32) | increased hours worked (J22) |
| increased investment (E22) | inefficient price signals (D61) |
| inefficient price signals (D61) | influence investment decisions in the real economy (G11) |
| low risk-free interest rates (E43) | enhance likelihood of boom-bust cycles (E32) |
| financial dynamics (G32) | periods of over- and underaccumulation of capital (E22) |
| boom in stock prices (E32) | new investments (G31) |