Reconnecting Investment to Stock Markets: The Role of Corporate Net Worth Evaluation

77 Pages Posted: 1 Nov 2013

See all articles by Eddie Gerba

Eddie Gerba

Banco de España; London School of Economics & Political Science (LSE); CES Ifo Institute; European Central Bank

Date Written: August 1, 2013

Abstract

Following recent studies by the Bank of England that the low financial market confidence and low expectations about private sector profits over the next three years has lead to unusually low price-to-book ratios, we incorporate a stock market mechanism in a general equilibrium framework. More specifically, we introduce an endogenous wedge between market and book value of capital, and make investment a function of it in a standard financial accelerator model. The price wedge is driven by an information set containing expectations about the future state of the economy. The result is that the impulse responses to exogenous disturbances are on average two to three times more volatile than in the benchmark financial accelerator model. More- over, the model improves the matching of firm variables and financial rates to US data compared to the standard financial accelerator model. We also derive a model based quadratic loss function and measure the extent to which monetary policy can feed a bubble by further loosening the credit market frictions that entrepreneurs face. A policy that explicitly targets stock market developments can be shown to improve welfare in terms of minimizing the consumption losses of consumers, even when we account for incomplete information of central bankers regarding the current state of the economy.

Keywords: Asset price cycles, financial friction model, monetary policy, asset price targeting

JEL Classification: G32, E44, E52

Suggested Citation

Gerba, Eddie, Reconnecting Investment to Stock Markets: The Role of Corporate Net Worth Evaluation (August 1, 2013). Available at SSRN: https://ssrn.com/abstract=2347694 or http://dx.doi.org/10.2139/ssrn.2347694

Eddie Gerba (Contact Author)

Banco de España ( email )

Alcala 50
Madrid 28014
Spain
(+34)917088132 (Phone)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London WC2A 2AE
United Kingdom

CES Ifo Institute ( email )

Poschinger Str. 5
Munich, 01069
Germany

European Central Bank ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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