Working Paper: CEPR ID: DP308
Authors: Marcus Miller; Paul Weller
Abstract: We examine the effect of introducing stochastic shocks into a linear rational expectations model with saddlepoint dynamics generated by a forward looking asset price. We derive the fundamental differential equation governing the path of the asset price as a function of the 'sluggish' variable. The equation does not admit of closed form solutions in general, but we provide a complete qualitative characterization of the solution paths which are symmetric about equilibrium. The first application analyzes how financial markets might react to the implementation of fiscal stabilization policy where public expenditures are only adjusted when GNP moves outside a threshold around a target level. The second application examines exchange rate behavior in the presence of a currency subject to a known realignment rule requiring an adjustment to monetary polic.
Keywords: saddlepoint equilibria; stochastic dynamics; thresholds; currency bands
JEL Codes: 023; 321; 431
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stochastic shocks (D89) | asset prices (G19) |
| fiscal stabilization policy (E63) | bond prices (G12) |
| GNP thresholds (E10) | bond prices (G12) |
| monetary intervention expectations (E52) | exchange rate trajectory (F31) |
| threshold for realignment (D79) | exchange rate movements (F31) |