Stock Price Cycles and Business Cycles

Abstract

We present a unified and quantitatively credible explanation for the joint behavior of stock prices and business cycles. We consider a frictionless production economy with time-separable consumption preferences and perfectly áexible labor supply. Investors extrapolate past stock price gains but are rational otherwise. The model replicates a standard set of asset pricing and business cycle moments, as well as moments capturing the interaction between business cycles and stock prices. The model generates belief-driven stock price booms that are associated with a corresponding boom in hours worked and investment. Once the boom turns into a bust, output, hours and investment remain persistently depressed. The model predicts that 75% of the observed áuctuations in the price-dividend ratio and 13% of observed output áuctuations are attributable to subjective price extrapolation by investors.

JEL Classification: E32, G12